Archive for the 'Chinese Yuan (RMB)' Category

Over the last six years, the appreciation of the Chinese Yuan has been as reliable as a clock. Since 2005, when China tweaked the Yuan-Dollar peg, it has risen by 28%, which works out to 4.5% per year. If you subtract out the two year period from 2008-2010 during which the Yuan was frozen in place, the appreciation has been closer to 7% per year. There is no other currency that I know of whose performance has been so consistently solid, and best of all, risk-free!

As I wrote in an earlier post on the subject, the economic case for further appreciation is actually somewhat flimsy. When you factor in the 5-10% inflation that has eroded the value of the Yuan over the last few years, its appreciation in real terms has more than exceeded the 25-40% that economists and politicians asserted as the margin by which it was undervalued. While prices for many services remain well below western levels, prices for manufactured goods already equal or exceed those that Americans pay. (As a resident of China, I can assure you that this is the case!). Given that Chinese GDP per capita (a proxy for income) is 12 times less than in the US, that means that relative price levels in China are already significantly greater than the US. Thus, further appreciation would only cause further distortion.

Regardless, investors continue to brace for further appreciation, and expectations of 5-6% for the foreseeable future are the norm. Even futures contracts – which typically lag actual appreciation because of their non-deliverable nature – are pricing in higher expectations for appreciation. Perhaps the greatest indication is that 9% of all of the capital pouring into China is so-called “hot-money.” That means that despite the 27% appreciation to date, a substantial portion of investment in China is connected only to the expectation for further Yuan appreciation.

Even though the Yuan is not fully-tradeable, its continued rise has serious implications for forex markets. First of all, there will be follow-on effects for other currencies. Almost every emerging market economy competes directly with China, and all are thus keenly aware that China pegs its currency against the US dollar. By extension, many of these economies feel they have no choice but to intervene daily in forex markets to prevent their respective currencies from appreciating faster than the RMB.

At the very least, the appreciation in Asian and Latin American currencies will keep pace with the Yuan: “This is a long-term secular trend for emerging market currencies especially in Asia. Asian currencies have long been undervalued and they are on a convergence path with the United States and the G7 more broadly and that’s going to lead to an appreciation,” summarized one analyst.

All of this action will cause the dollar to depreciate. The Chinese Yuan alone accounts for 20% of the Federal Reserve Bank’s trade-weighted dollar index, and Asia ex-Japan accounts for another 20%. Regardless of the other G4 currencies perform, that means that a conservative 7% annual appreciation in Asia will drive a minimum 3% annual decline in the trade-weighted value of the dollar. Even worse is that this cause a broad loss of confidence in the dollar, driving the dollar lower across-the board. And this doesn’t even aaccount for the multiplier effect that net exporters will no longer need to indiscriminately accumulate dollar-denominated assets. China, itself, has unloaded part of its massive hoard of US Treasury securities for five consecutive months.

The implications for how long-term investors should position themselves are clear. Unfortunately, while further appreciation in the Chinese Yuan is all but guaranteed, achieving exposure to this appreciation is beyond difficult. Neither of the ETFs that claim to represent the Yuan (CNY, CYB) have budged over the last couple years, and they are a poor substitute for the actual thing. In other words, your only chance for exposure is indirectly via Chinese stocks and bonds, which are far from transparent and an extremely dubious investment. Or you could try opening a Chinese Yuan bank account with the Bank of China (which now has branches in the US), but it’s unclear whether you will be able to capture 100% of gains from the Yuan’s appreciation.

Otherwise, emerging market Asia seems like a pretty good proxy. Of course, you need to be aware that even though the Korean Won, Malaysian Ringgit, Thai Baht, New Taiwan Dollar, Indonesian Rupiah, Philippine Peso, etc. will probably at least match the rise in the Yuan, they are imperfect substitutes for the Yuan, since they are driven more by country-specific factors than by association to China.

The Chinese yuan has appreciated by more than 27.5% since 2005, when the People’s Bank of China (“PBOC”) formally acceded to international pressure and began to relax the yuan-dollar peg. For China-watchers and economists, that the Yuan will continue to appreciate is thus a given. There is no question of if, but rather of when and to what extent. But what if the prevailing wisdom is wrong? What if the yuan is now fairly valued, and economic fundamentals no longer necessitate a further rise?

Prior to the 2005 revaluation, economists had argued that the yuan (also known as the Chinese RMB) was undervalued by 15% – 40%, and American politicians had used this as a basis for proposing a 27.5% across-the-board tariff on all Chinese imports. Given that the yuan has now appreciated by this exact margin (and by even more when inflation is taken into account), shouldn’t this alone be enough to silence the critics, without even having to look at the picture on the ground? How can Senator Charles Schumer continue to press for further appreciation when the yuan’s rise exceeds his initial demands? Alas, election season is upon us, and we can’t hope to make political sense out of this issue. We can, however, attempt to analyze the economic sense of it.

China manipulates the value of the yuan in order to give a competitive advantage to Chinese exporters, goes the conventional line of thinking. Look no further than the Chinese trade surplus for evidence of this, right? As it turns out, China’s trade surplus is shrinking rapidly. In 2006, it was a whopping 11% of GDP. Last year, it had fallen to 5%, and it is projected by the World Bank to settle below 3% for each of the next two years. Thanks to a first quarter trade deficit – the first in over seven years – China’s trade surplus may account for a negligible portion (~.2%) of GDP growth in 2010.

With this in mind, why would the PBOC even think about allowing the RMB to appreciate further? According to one perspective, the narrowing trade imbalance is only temporary. When commodities prices settle and global demand fully recovers, a wider trade surplus will follow. In fact, the IMF forecasts China’s current surplus will rise to 8% by 2016. As you can see from the chart below (courtesy of The Economist), however, the IMF’s forecasts have proven to be too pessimistic for at least the last three years, and it now has very little credibility. Besides, China’s economy is gradually reorienting itself away from exports and towards domestic spending. As a resident of China, I can certainly attest to this phenomenon, and the last few years has seen an explosion in the number of cars on the road, domestic tourism, and conspicuous consumption.

A better argument for further RMB appreciation comes in the form of inflation. At 5.4%, inflation is officially nearing a 3-year high, and there is evidence that the PBOC already recognizes that allowing the RMB to keep rising represents its best tool for containing this problem. It has already raised banks’ required reserve ratio several times, but there is a limit to what this can accomplish. Meanwhile, the PBOC remains reluctant to raise interest rates because it will invite further “hot-money” inflows (estimated at more than $100 Billion per year, if not much higher) and potentially destabilize the banking sector. By raising the value of the yuan, the PBOC can blunt the impact of rising commodities prices and other inflationary forces.

In fact, some think that the PBOC will quicken the pace of appreciation, a view that as supported by last month’s .9% rise. Others think that a once-off appreciation would be more effective, and is hence more likely. This would not only remove the motivation for further hot-money inflows, but would also reduce the PBOC’s need to continue accumulating foreign exchange reserves. At $3 trillion+ ($1.15 trillion of which are held in US Treasury Securities), these reserves are already a massive headache for policymakers. Merely stating the obvious, PBOC Governor Zhou Xiaochuan has officially called the reserves “really too much.” (It’s worth pointing out that the promotion of the yuan as an international currency is backfiring in some ways, causing the reserves to balloon even faster).

For the record, I think that the Chinese yuan is pretty close to being fairly valued. That might seem like a ridiculous claim to make when Chinese wages and prices are still well below the global average. Consider, however, that the same is true for the majority of emerging market economies, including those that don’t peg their currencies to the dollar. That doesn’t mean that the yuan won’t – or that it shouldn’t – continue to rise. In fact, the PBOC needs to do more to ensure that the Yuan appreciates evenly against all currencies, since most of the yuan’s rise to-date has taken place relative to the US Dollar. It’s merely a commentary that the PBOC is close to fulfilling the promises it has made regarding the yuan, and going forward, I think that observers should expect that its forex policy will be reconfigured to promote domestic macroeconomic policy objectives.

This week’s Bank of International Settlements (BIS) quarterly report came with some interesting revelations (most of which I’ll discuss in a later post). Below, I’d like to focus on one particularly interesting section entitled, “Foreign exchange trading in emerging currencies.” This section carries tremendous implications for the future of reserve currencies and is a must read for fundamental analysts.

According to the BIS, “Foreign exchange turnover evolves in a predictable fashion with increasing income. As income per capita rises, currency trading cuts loose from underlying current account transactions…moreover, currencies with either high or very low yields attract more trading, consistent with their role as target and funding currencies in carry trades.” In other words, the most liquid currencies (and hence, most suitable reserve currencies) are primarily those of advanced economies and secondarily those with abnormal interest rates.

In theory, one would expect a close correlation between forex turnover and trade. In fact, this turns out to be precisely the case for lesser-developed countries. Since the capital markets of such countries are commensurately undeveloped, offering limited opportunities for foreign investment, most of the demand for their currencies stems directly from trade. In fact, the currencies of Malaysia, Indonesia, Saudi Arabia, and (notably) China closely fit this profile, with a 1:1 ratio between forex turnover and trade.

At the same time, the BIS discovered a strong correlation between the ratio of foreign exchange turnover to trade and GDP per capita. That means that as a country grows economically and enters the realm of industrialized countries, its currency will experience exponential growth in turnover. For example, the British Pound and Japanese Yen are exchanged at a quantity that is 50 times greater than required for trading purposes. The ratio of forex turnover to trade for the US Dollar, meanwhile, exceeds 100!

The BIS was able to fit a regression line to the data that seemed to explain this phenomenon quite well. The majority of economies/currencies that it surveyed fall pretty close to this line, suggesting that forex turnover is exactly where it should be relative to GDP per capita and trade. In fact, the line runs directly through the Euro, Hong Kong Dollar, Canadian Dollar, and Swedish Krona, and Norwegian Krona.

There are also plenty of outliers. Given the size of China’s economy, for instance, the model would predict that turnover in the Chinese Yuan should be 2-3 times what it currently is. Unsurprisingly, all of the world’s major reserve currencies (except for the Euro) can be found well on the other side of the regression line. Turnover in the US Dollar, Japanese Yen, and Australian Dollar is almost twice as high as the model predicts. Perhaps the most flagrant outlier is the New Zealand Dollar, which seems to be traded at a frequency that is 8-10x higher than it should be. Of course, New Zealand is a unique case; there isn’t another economy that is as small and stable, and yet always has higher-than-average interest rates.

One interpretation of this analysis is that demand for the all of the currencies that fall above the regression line should decline over time, and should experience at least some depreciation. The opposite can be said for currencies that currently fall the regression line, especially if their economies continue to expand at a faster-than average pace.

At the same time, it puts things into perspective. Even if demand for the Chinese Yuan doubled in accordance with the BIS model (which would necessitate looser capital controls, among other things), GDP per capital would need to increase 20x and US GDP per capita would need to remain constant in order for the Yuan to rival the Dollar in importance. Also, I’m beginning to wonder if the New Zealand Dollar isn’t in fact oversubscribed and overvalued…

Since the People’s Bank of China (PBOC) unfixed the Chinese Yuan in June, it has appreciated 4.5%. Moreover, for a handful of reasons, it looks like China will continue allowing the RMB to appreciate at the same steady pace for the foreseeable future. And yet, the international community continue to use China as a scapegoat for all global economic ills, and are pressuring it to stop trying to control the Yuan altogether.

At the recent G20 conference in China, US Treasury Secretary Tim Geithner circumvented China’s request to avoid discussing its currency policy: “Flexible exchange rates help countries better absorb shocks and that the tension between flexible currencies and those that are ‘tightly managed’ is ‘the most important problem to solve in the international monetary system today.’ ” Naturally, Chinese officials countered that the Dollar is to blame for the recent financial crisis and the ongoing economic imbalances.

If China was the only country to attempt to control its currency, perhaps the rest of the world would be willing to overlook it and write it off to ideological differences like they do with many of its protectionist economic policies. In this case, however, China’s tight control of the Yuan has spurred many of the countries with which it competes to similarly intervene in forex markets. In the last week alone, South Korea, Malaysia, Singapore, and Thailand are all suspected of buying Dollars to hold down their respective currencies. Meanwhile, Brazil is enhancing its capital controls and Japan stands ready to intervene should the Yen spike again.

To quote Secretary Geithner again, “This asymmetry [between nations that intervene and those that don’t] in exchange rate policies creates a lot of tension. It magnifies upward pressure on those emerging-market exchange rates that are allowed to move and where capital accounts are much more open. It intensifies inflation risk in those emerging economies with undervalued exchange rates. And, finally, it generates protectionist pressures.” In short, when one country decides not to play the rules, other countries are quick to catch on. [To be fair, while the US doesn’t intervene directly on behalf of the Dollar, it still deserves some blame for this tension because of QE2 and the like].

If any country appears to be taking these lessons to heart, however, it is China. To combat inflation, it has raised interest rates several times over the last twelve months, including yesterday’s surprise 25 basis point hike. Given that official inflation remains above 5% (and living here, I can tell you that the actual rate is probably 10-20%), the PBOC has no choice but to continue tightening monetary policy if it wishes to avoid social unrest. To counter the inevitable upward pressure on the Yuan, it has taken such measures as prodding Chinese firms to look abroad for acquisition targets. China’s forex policy is designed to serve one very important end: to buttress the competitiveness of its export sector. However, there are early indications that China’s preeminent position as the world’s sweatshop may be about to slide. Anecdotal reports show that manufacturers are unnerved by wage and raw materials inflation, and are uprooting factories. In the short-term, some of this production will move inland from the coast, but even this has its limits. According to Credit Suisse, “Salaries for China’s estimated 150 million migrant workers will rise 20 to 30 percent a year for the next three to five years…’It may take a decade for China to see its export competitiveness erode, but we have seen the beginning of this happening.’ ”

With this in mind, it’s clearly futile for China to continue to focus its economic policy around low-cost, labor-intensive exports. Likewise, it’s ridiculous to continue to artificially depress the Yuan, especially if it’s serious about turning it into a global reserve currency. I think Chinese policymakers recognize this, and I stand by my earlier prediction that the Yuan will maintain a steady pace of appreciation for the foreseeable future.

Last month, the G20 finally agreed on the specific factors that would be used to determine whether a country was manipulating its currency. Despite being watered-down (by the usual suspects), the so-called “scorecard” is nonetheless extremely substantive. Unfortunately, the resolution will be backed only by “peer pressure,” rather than any kind of real enforcement mechanism, which means that in practice it is basically worthless.

While the proximate goal of the resolution is to eliminate exchange rate manipulation, it’s ultimate goal is to minimize the risk of another economic/financial crisis. Towards that end, a country’s “budget deficit levels, the external imbalance and private savings rates” will be closely scrutinized, and will be warned if any of these factors reach levels that are deemed to be unsustainable. The idea is that an early warning system will prevent the global economy from reaching a point of disequilibrium that is so severe that crisis would be impossible to avert.

Of course, the problems with this program are manifold. First of all, there are no concrete numbers. For example, it’s not clear how large a country’s national debt or trade deficit has to reach before it receives a phone call and slap on the wrist from the G20. In fact, you could argue that the same imbalances that precipitated the crisis are largely still in place, which means that some countries should have been warned yesterday.

Second, there is no meaningful enforcement mechanism. That means that countries that disregard the resolution don’t really have anything to fear, other than the wrath of investors. In other words, if governments and Central Banks know that they can manipulate their exchange rates with impunity, what’s to stop them? Look at Japan: its public debt is the highest in the world. It runs a perennial trade surplus. Its citizens are notorious savers. And yet, when the Yen rose to a record high, which you might expect from such an imbalanced economy, the G7 (in this case) took the unusual step of pushing the Yen down. I’m not saying this wasn’t the right thing to do, but what kind of signal does this send to other rule breakers.

While all emerging market countries took an active interest in exchange rates (and seek to exert some control over their currencies), China is certainly Public Enemy #1, and is the clear target of the “currency manipulation” talk. To its credit, the People’s Bank of China (PBOC) has permitted the Chinese Yuan to appreciate 20% against the Dollar (probably 30% when inflation is taken into account) over the last few years. Meanwhile, both internal government statisticians and the IMF expect its current account surplus to narrow to a mere 5% in 2011, as its economy slowly rebalances.

In this sense, I think China is a case in point that the best enforcement mechanism is reality. Specifically, China has reached a point where it cannot continue to pursue an economic policy based on exports, without spurring inflation and causing the inefficient allocation of domestic capital (such as in real estate). It must raise interest rates and accept the continued appreciation of the RMB is an unavoidable byproduct.

The same goes for other countries that attempt to hold their currencies down. If they can get away with it, then so be it. If not, I can guarantee that it won’t be the G20 that forces them to change.

Relatively speaking, the Chinese Yuan has been on a tear, appreciating ~1% in a little more than a month. One has to wonder whether this is a concession by the People’s Bank of China (PBOC) that its exchange rate regime is not viable or whether its instead a political sop. The question on everyone’s minds, of course, is, will it continue?

Countries around the world have continued to criticize China for its unwillingness to allow the Yuan to appreciate. At last week’s G20 meeting, US Treasury Secretary Timothy Geithner and Fed Chairman Ben Bernanke separately took aim. “They’re still heavily leaning against the forces trying to push their currency up,” complained Geithner. “The maintenance of undervalued currencies by some countries has contributed to a pattern of global spending that is unbalanced and unsustainable,” intimated Bernanke.

However, it was only when fellow emerging market economies – namely Brazil – voiced similar concerns, that China was finally forced to concede partial defeat. It signed on to an official G20 communique that declared that exchange rates and current account balances would be used to determine whether a particular country’s policies were contributing to global economic imbalances. Alas, the Communique (and the G20, for that matter) is deliberately vague and unenforceable; it’s more symbolic than anything else.

Still, China is not one to take its cues – especially on issues as important as the Yuan – from the international community. That the Yuan is now appreciating at a steady clip (~5% in annualized terms) is almost certainly being driven more by pragmatism than politics. Specifically, it represents the most effective tool to combat inflation, which has already breached 5% and continues to tick higher.

China critics forget that China’s fixed exchange rate regime is not a free lunch. While it almost certainly gives the export sector a competitive advantage, it also deprives the PBOC of the ability to conduct monetary policy and is inherently inflationary. That’s because the policy necessitates soaking up all of the foreign currency that enters the country (hence the ~$3 Trillion in forex reserves) and instead printing new Chinese Yuan and putting into circulation. When you combine a 15% annual increase in the money supply with soaring economic growth, a surge in bank lending, real estate boom, and rising commodity prices, the inevitable result is inflation. The country’s economic officials have responded by tightening credit and raising interest rates, but these will ultimately fail as long as the Fed’s QE2 program continues to send US Dollars into China.

In addition to allowing the Yuan to slowly appreciate, China has also moved to make the Yuan more convertible. This has the dual advantages of making China less reliant on the US Dollar and on relieving upward pressure on the Yuan. More of its trade is being settled directly in Chinese Yuan. Chinese companies are being encouraged to invest outside of China, and foreign companies inside of China are gradually being permitted to issue Yuan-denominated bonds, rather than import Dollars to fund new investments.

It appears that all of these measures are actually starting to have some impact. China’s trade surplus is shrinking. The IMF has suggested that the Chinese Yuan could one day be an international reserve currency and could be a component of its Special Drawing Rights (SDR) currency. Less hot money (distinct from investment inflows) is finding its way into China.

Unfortunately, most analysts are skeptical that it will last. Futures markets reflect a modest 2.5% appreciation against the Dollar over the next 12 months. I’m personally anticipating a rise of 4-5%, though I think it will ultimately be tweaked depending on inflation.

At the very end of 2010, the Chinese Yuan managed to cross the important psychological level of 6.60 USD/CNY, reaching the highest level since 1993. Moreover, analysts are unanimous in their expectation that the Chinese Yuan will continue rising in 2011, disagreeing only on the extent. Since the Yuan’s value is controlled tightly by Chinese policymakers, forecasting the Yuan requires an in-depth look at the surrounding politics.

While American politicians chide it for not doing enough, the Chinese government nonetheless deserves some credit. It has allowed the Yuan to appreciate nearly 25% in total, which should be just enough to satisfy the 25-40% that was initially demanded. Meanwhile, over the last five years, China’s trade surplus has fallen dramatically, to 3.3% of GDP in 2010, compared to a peak of 11% in 2007. In fact, if you don’t include trade with the US, its surplus was basically nil this year.

Therein lies the problem. Despite the fact that prices in Chinese exports should have risen 25% (much more if you take inflation and rising wages into account) since 2004, the China/US trade balance has remained virtually unchanged, and its current account surplus has actually widened. As a result, China’s foreign exchange reserves increased by a record amount in 2010, bringing the total to a whopping $2.9 Trillion! (Of course, these reserves should be thought of as a monetary burden rather than pure wealth, to the same extent as the US Federal Reserve Board’s Balance Sheet must one day be wound down. In the context of this discussion, however, that might be a moot point).

Meanwhile, China is trying to slowly tilt the structure of its economy towards domestic consumption, which is increasing by almost every measure. Its Central Bank is also slowly hiking interest rates and raising the reserve requirements of banks in order to put the brakes on economic growth and rein in inflation. Finally, it is trying to encourage internationalization of the Yuan. There now 70,000 Chinese trade companies that are permitted to settle trades in Chinese Yuan. In addition, Bank of China just announced that US customers will be able to open up Yuan-denominated accounts, and the World Bank became the latest foreign entity to issue an RMB-denominated “Dim-Sum Bond.”

There is also evidence that the Chinese Government’s top leadership – with whom the US government directly negotiates – is actually pushing for a faster appreciation of the RMB but that it faces internal opposition. According to the New York Times, “The debate over revaluing the renminbi… has not advanced much partly because of a fight between central bankers who want the currency to rise and ministers and party bosses who want to protect the vast industrial machine that depends on cheap exports for survival.” In fact, the Bank of China (PBOC) recently warned, “Factors such as the country’s trade surplus, foreign direct investment, China’s interest rate gap with Western countries, yuan appreciation expectations, and rising asset prices are likely to persist, drawing funds into the country,” while a senior Chinese lawmaker pushed back that a “rise in the yuan’s value won’t help the country to curb inflation.”

Some analysts expect a big move in the Yuan that corresponds with this week’s US visit by China’s Prime Minister, Hu Jintao. The average call, however, is for a continued, steady rise. “China’s currency will strengthen 4.9 percent to 6.28 by the end of 2011, according to the median estimate of 19 analysts in a Bloomberg survey. That’s over double the 2 percent gain projected by 12-month non-deliverable forwards.” As I wrote in my previous post on the Chinese Yuan, however, it ultimately depends on inflation – whether it keeps rising and if so, how the government chooses to tackle it.

Based on nominal exchange rates, the Chinese Yuan has appreciated by a modest 2% against the US Dollar since the month of September (when the People’s Bank of China (PBOC) adjusted the currency peg for the first time in nearly two years). If you take inflation into account, however, the Chinese Yuan has risen by much more. In fact, if current trends persist, the Chinese Yuan exchange rate controversy might resolve itself.

Demands from the international community for China to appreciate its currency hinge on two related arguments. The first is that at its current level, the artificially low exchange has allowed China to build up a massive trade surplus. The second is that Chinese prices seem to be lower than they should be (when quoted in other currencies), and the economic principle of Purchasing Power Parity (PPP) suggests that for this discrepancy to be eliminated, the Chinese Yuan must rise.

As it turns out, both of these claims are more problematic than they would appear. For example, China’s official trade surplus is already massive, and is steadily increasing. For 2010, it will probably near $200 Billion. However, it turns out that majority of that surplus is being captured by foreign-funded companies: “Their 112.5-billion U.S.-dollar surplus accounts for 66 percent of China’s total surplus over the past 11 months.”

In addition, trade statistics are calculated in such a way that the country that assembles the finished product gets credit for the full export value of that product. By looking specifically at Apple’s popular iPhone, researchers calculated that the product officially contributed $2 Billion to the US trade deficit with China. When the nuances of the iPhone’s supply chain are taken into account, that figure swings to a surplus of $48 million. In both of these cases, the fact that these products are manufactured in China doesn’t detract from US GDP (though it probably does cost the US jobs). Hence, the US probably isn’t hurting as much from the weak RMB to the extent that some lobbyists insist.

As for inflation, the official rate is now 5.1% on an annualized basis. Even if we accept this (and living in China, I can tell you that the actual rate is much, much higher), that means that the value of other currencies is eroding at a much faster rate than is implied by official exchange rates. That’s because a currency is only worth its purchasing power; as prices and wages in China rise, the purchasing power of the US Dollar (and other currencies) falls.

The Chinese government is trying to address the problem in the form of price controls and mandated increases in supply, but it is still reluctant to rein in inflation using conventional monetary policy measures. M2 money supply in China is increasing at a rate of 20% a year, the majority of which is being spent on another boom in fixed asset investment. While the PBOC has responded by increasing the required reserve ratio of Chinese banks, it remains reluctant to raise interest rates lest it contribute to further inflows of “hot money” on more upward pressure on the Yuan. As a result, the consensus among economists is that inflation will continue rising unabated: “We see a strong chance of underlying price pressures continuing to build over the medium-term.”

Unless circumstances change, then, the argument for further RMB appreciation is somewhat weak. Nonetheless, analysts remain optimistic: “A Bloomberg survey based on the median estimates of 20 analysts predicts the yuan to increase 6.1 percent to 6.28 percent by the end of 2011.” Given that Hu Jintao is schedule to visit the US in January – and China’s fondness for symbolic policy gestures – a token move of 1% or so before then wouldn’t be surprising. As for the predicted 6% rise next year, well, that depends on inflation.

In a recent editorial reprinted in The Business Insider (Here’s Why The Yuan Will Never Be The World’s Reserve Currency), China expert Michael Pettis argued forcefully against the notion that the Chinese Yuan will be ever be a global reserve currency on par with the US Dollar. By his own admission, Pettis seeks to counter the claim that China’s rise is inevitable.

The core of Pettis’s argument is that it is arithmetically unlikely – if not impossible – that the Chinese Yuan will become a reserve currency in the next few decades. He explains that in order for this to happen, China would have to either run a large and continuous current account deficit, or foreign capital inflows into China would have to be matched by Chinese capital outflows.” Why is this the case? Simply, a reserve currency must necessarily offer (foreign) institutions ample opportunity to accumulate it.

However, as Pettis points out, the structure of China’s economy is such that foreigners don’t have such an opportunity. Basically, China has run a current account/trade surplus, which has grown continuously over the last decade. During that time, its Central Bank has accumulated more than $2.5 Trillion in foreign exchange reserves in order to prevent the RMB from appreciating. Foreign Direct Investment, on the other hand, averages 2% of GDP and is declining, not to mention that “a significant share of those inflows may actually be mainland money round-tripped to take advantage of capital and tax regulations.”

For this to change, foreigners would need to have both a reason and the opportunity to hold RMB assets. The reason would come from a reversal in China’s balance of trade, and the use of RMB to pay for the excess of imports over exports, which would naturally imply a willingness of foreign entities to accept RMB. The opportunity would come in the form of deeper capital markets, a complete liberalization of the exchange rate regime (full-convertibility of the RMB), and the elimination of laws which dictate how foreigners can invest/lend in China. This would likewise an imply a Chinese government desire for greater foreign ownership.

How likely is this to happen? According to Pettis, not very. China’s financial/economic policy are designed both to favor the export sector and to promote access to cheap capital. In practice, this means that interest rates must remain low, and that there is little impetus behind the expansion of domestic consumption. Given that this has been the case for almost 30 years now, this could prove almost impossible to change. For the sake of comparison, consider that despite two “lost decades,” Japan nonetheless continues to promote its export sector and maintains interest rates near 0%.

Even if the Chinese economy continues to expand and re-balances itself in the process (a dubious possibility), Pettis estimates that it would still need to increase the rate of foreign capital inflows to almost 10% of GDP. If economic growth slows to a more sustainable level and/or it continues to run a sizable trade surplus, this figure would rise to perhaps 20%. In this case, Pettis concedes, “we are also positing…a radical change in the nature of ownership and governance in China, as well as a radical redrawing of the role of the central and local governments in the local economy.”

So there you have it. The political/economic/financial structure of China is such that it would be arithmetically very difficult to increase foreign accumulation of RMB assets to the extent that the RMB would be a contender for THE global reserve currency. For this to change, China would have to embrace the kind of reforms that go way beyond allowing the RMB to fluctuate, and strike at the very core of the CCP’s stranglehold on power in China.

If that’s what it will take for the RMB to become a fully international currency, well, then it’s probably too early to be having this conversation. Perhaps that’s why the Asian Development Bank, in a recent paper, argued in favor of modest RMB growth: “sharing from about 3% to 12% of international reserves by 2035.” This is certainly a far cry from the “10 years” declared by Russia’s finance minister and tacitly supported by Chinese economic policymakers.

The implications for the US Dollar are clear. While it’s possible that a handful of emerging currencies (Brazilian Real, Indian Rupee, Russian Ruble, etc.) will join the ranks of the international currencies, none will have enough force to significantly disrupt the status quo. When you also take into account the economic stagnation in Japan and the UK, as well as the political/fiscal problems in the EU, it’s more clear than ever that the Dollar’s share of global reserves in one (or two or three) decades will probably be only slightly diminished from its current share.

China’s foreign exchange reserves continue to surge. As of September, the total stood at $2.64 Trillion, an all-time high. However, it’s becoming abundantly clear that China is no longer content for Dollar-denominated assets to represent the cornerstone of its reserves. Instead, it has embarked on a campaign to further diversify its reserves, with important implications for the currency markets.

Despite China’s allowing the Chinese Yuan to appreciate (or perhaps because of it), hot money continues to flow in – nearly $200 Billion in the the third quarter alone. Foreign investors are taking advantage of strong investment prospects, rising interest rates, and the guarantee of a more valuable currency. In order to prevent the inflows from creating inflation and putting even more upward pressure on the RMB, the Central Bank “sterilizes” the inflows by purchasing an offsetting quantity of US Dollars and other foreign currency.

Since the Central Bank does not release precise data on the breakdown of its reserves, analysts can only guess. Estimates range from the world average of 62% to as high as 75%. At least $850 Billion (this is the official tally; due to covert buying through offshore accounts, the actual total is probably higher) of its reserves are held in US Treasury securities. It also controls a $300 Billion Investment Fund, which has made very public investments in natural resource companies around the world. The allocation of the other $1.5 Trillion is a matter of speculation.

Still, China has stated transparently that it wants to diversify its reserves into emerging market currencies, following the global shift among private investors. Investment advisers praise China for its shrewdness, in this regard: “The Chinese authorities are some of the smartest in the world. If you look at the fundamentals of a lot of these emerging markets, they are considerably better than developed markets. Who wants to be holding U.S. dollars at this stage?” However, these investments serve two other very important objectives.

The first is diplomatic/political. When China recently signed an agreement with Turkey to conduct bilateral trade in Yuan and Lira (following similar deals with Brazil and Russia), it was interpreted as an intention snub to the US, since trade is currently conducted in US Dollars. In addition, by funding projects in other emerging markets through a combination of loans investments, China is able to curry favor with host countries, as well as to help its own economy at the same time. The second is financial: by buying the currencies of trade rivals, China is able to make sure that its own currency remains undervalued. This year, it has already purchased more than $5 Billion in South Korean bonds, and perhaps $20 Billion in Japanese sovereign debt, sending the Won and the Yen skywards in the process.

China’s purchases of Greek and (soon) Italian debt serve the same function. It is seen as an ally to financially troubled countries, while its efforts help to keep the Euro buoyant, relative to the RMB. According to Chinese Premier Wen JiaBao, “China firmly supports Greece’s efforts to tackle the sovereign debt crisis and won’t cut its holdings of European bonds.”

For now, China remains deeply dependent on the US Dollar, and is still very vulnerable to a sudden depreciation it its value. For as much as it wants to diversify, the supply of Dollars and the liquidity with which they can be traded means that it will continue to hold the bulk of its reserves in Dollar-denominated assets. In addition, the Central Bank has no choice but to continue buying Dollars for as long as the RMB remains pegged to it. At some point in the distant future, the Yuan will probably float freely, and China won’t have to bother accumulating foreign exchange reserves, but that day is still far away. For as long as the peg remains in place, the Dollar’s status as global reserve currency is safe.

There are plenty of investors that think betting on China is as close to a sure thing as there could possibly be. The only problem is that investing directly in China’s economic freight train is complicated, opaque, and sometimes impossible. The Chinese government maintains strict capital controls, prohibits foreigners from directly owning certain types of investment vehicles, and prevents the Chinese Yuan from appreciating too quickly, if at all. For those that want exposure to China without all of the attendant risks, there is a neat alternative: the Australian Dollar (AUD).

Those of you that regularly read my posts and/or follow the forex markets closely should be aware of the many correlations that exist between currencies and other financial markets, as well as between currencies. In this case, there would appear to be a strong correlation between Chinese economic growth and the Australian Dollar. If the Chinese Yuan were able to float freely, it might rise and fall in line with the AUD. Since the Yuan is fixed to the US Dollar, however, we must look for a more roundabout connection. HSBC research analysts used Chinese electricity consumption as a proxy for Chinese economic activity (why they didn’t just use GDP is still unclear to me), and discovered that it fluctuated in perfect accordance with the Australian Dollar.

Before I get ahead of myself, I want to explain why one would even posit a connection between China and the Aussie in the first place. There are actually a few reasons. First, Australia is economically part of Asia: “Today, 43 per cent of Australia’s total merchandise trade is with north Asia. A further 15 per cent is with Southeast Asia.” Second, Australia’s economy is driven by the extraction and sale of natural resources, of which China is a major buyer and investor: “In 2008-9, China was the biggest investor in the key resource sector with $26.3bn involvements approved, 30 per cent of the total.” Third, Chinese demand has come to dictate the prices of many such resources, causing them to rise continuously. Thus, Australia’s natural resource exports to countries other than China still draw strength (via high commodity prices) from Chinese demand.

As one analyst summarized, “China is buying raw materials from Australia in leaps and bounds, and that’s what’s driving that currency’s growth.” Sounds like an Open and Shut case. In fact, this presumed correlation has become so entrenched that any indication that China is trying to cool its own economy almost always prompts a reaction in the Aussie. To be sure, warnings that China’s annual legislative conference (scheduled for October 17) would produce a consensus call for a tightening of economic policy have made some forecasters more conservative. Still, as long as the Chinese economy remains strong, the Australian Dollar should follow.

It’s worth pointing out that the correlation between the Aussie and the Chinese economy doesn’t exist in a vacuum. For example, the Australian Dollar has also closely mirrored the S&P 500 over the last decade, which suggests that global economic growth (and higher commodity prices) are as much of a factor in the Aussie’s appreciation as is Chinese economic activity. The Aussie is also vulnerable to a decline in risk appetite, like the kind that took place during the financial crisis and flared up again as a result of the EU Sovereign debt crisis. During such periods, Chinese demand for commodities becomes irrelevant.

On the other hand, part of the reason the Australian Dollar has surged 10% since September and 20% since June is because other countries’ Central Banks (such as China) have increased their interventions on behalf of their respective currencies. Australia is one of a handful of countries whose Central Bank not only hasn’t actively tried to depress its currency, but whose monetary policy (via interest rate hikes) actually invites further appreciation. As the Aussie closes in on parity and Australian exporters and tourism operators become more vocal about the impact on business, however, the Reserve Bank of Australia (RBA) might be forced to act.

The Chinese Yuan has touched a new high, at 6.69 USD/CNY. Given that the Yuan has still only risen about 2% since the peg was officially loosened in June – with most of that appreciation taking place in the last couple weeks – there still remains intense pressure on China to do more.

Last week’s intervention by the Bank of Japan diverted a tremendous amount of attention towards the Yuan. In fact, many analysts have argued that it is only because of the Yuan-Dollar peg (itself, as well as the Chinese purchases of Yen assets that it engendered) that Japan was forced to act: ” ‘Countries see that getting involved in currency manipulation is a way to give themselves an advantage’…’China, their actions affected Japan, and Japan is affecting us.’ ” The Yen intervention could also force the G20 to re-focus its attention on the Yuan, and at least devote some discussion to it at the next summit.

It should be noted that the two soundbites above both emanated from US Congressmen, which is important because the US government is currently mulling action on the Yuan currency peg. Politicians are growing tired by the Treasury Department’s repeated failure to call China a “Currency Manipulator,” which would require diplomatic talks and even trade sanctions. The Treasury will have an opportunity redeem itself in its next report on foreign exchange, due out on October 15, but it is expected that the report will either be delayed or released without adequately addressing the undervalued Yuan.

In fact, Treasury Secretary Geithner testified before Congress last week, and at least admitted that something needed to be done: “The pace of appreciation has been too slow and the extent of appreciation too limited. We have to figure out ways to change behavior.” However, this was only in response to acerbic criticism – (Senator Schumer told him, “I’m increasingly coming to the view that the only person in this room who believes China is not manipulating its currency is you.”) – and he ultimately failed to outline a timetable/blueprint for action. Despite the consensus among politicians (and President Obama) that the currency peg is harmful to the US economy, Geithner made it clear that the Treasury Department continues to favor unilateral action towards dealing with problem, without Congressional intervention. For now, then, politicians are probably relegated to saber-rattling and name-calling.

China’s response to this charade has been predictable. Trade representatives hinted that China wouldn’t bow to external pressure, and that any attempt at “punishment” would be met with countervailing actions. China also questioned the economics between arguments that the Dollar peg contributes to trade imbalance, calling such claims “groundless.” This position is actually supported by the notion that while the Yuan appreciated by 20% against the Dollar from 2005-2008, the US/China trade deficit actually widened.

In practice, China is likely to stick to its policy of gradual Yuan appreciation, or a few reasons. First of all, while Chinese policymakers know that they don’t need to wholly appease US politicians, they at least need to pretend that they are listening. It’s true that the US is dependent on Chinese products and its purchases of Treasury Bonds. However, it is arguably just as dependent on the US to buy its exports, which promotes employment and social stability, and it is keen to avoid a trade war if possible.

Second, a long-term appreciation of the RMB is actually in China’s best interest. If it wants to spur domestic consumption and promote more value-added manufacturing, it will need a more valuable currency. Outbound M&A, especially involving natural resource companies, will also be more economical if the Yuan is worth more. Also, if China has any serious ambitions of turning the Yuan into a global reserve currency, it will need to create capital markets that are deeper and more liquid, which it is currently unmotivated to do, lest it spur demand for Yuan by foreign institutional investors.

Finally, China should let the Yuan appreciate because it is financially gainful to do so. As I mentioned above, its trade surplus with the US has widened over the last few years as prices for its exports grow along with quantity. Meanwhile, prices for imports and prices paid for commodities and other natural resources have declined in Yuan-terms. For that reason, I think China will probably continue to stick its current policy, and allow the RMB to continue to slowly inch up.

The frequency of my reports on the Chinese Yuan is admittedly much higher than it used to be. Why? Call it disbelief. More than two months have passed since China revalued its currency, and after a rapid 1% appreciation, the RMB has actually fallen back. Today, it stands only .5% higher against the Dollar compared to June 18. On a trade-weighted basis, it is actually 2.3% lower. What is going on?!

It can foremost be attributed to a disconnect between Chinese words and Chinese action. While The People’s Bank of China (PBOC) purportedly supports a stronger, flexible Yuan (“Adopting a more flexible exchange-rate regime serves China’s long-term interests as the benefits…far exceed the cost in reorganising industries and removing outdated capacities.”), in practice, it has prevented the currency from budging. On numerous occasions since supposedly allowing the RMB to appreciate, it has intervened in the forex markets through various shadow dealers to prevent this very outcome.

In fact, China has increased its purchases of South Korean and Japanese sovereign debt, ostensibly as part of its diversification strategy, but more likely to put upward pressure on those currencies. “Data from Japan’s Ministry of Finance show that China bought a net 1.73 trillion yen ($20.3 billion) of Japanese government bonds in the first half of this year, compared with a net sale of 5.9 billion yen ($69 million) a year earlier. That strong demand has been a key factor strengthening the yen in recent weeks.” This could have broad implications, since in the last quarter, China accumulated $81 Billion in new forex reserves, and seems intent on further diversifying out of US Dollar-denominated assets.

China’s general obstinacy towards in dealing with the Yuan is baffling to market observers, especially given the trade surplus of nearly $30 Billion in June, its largest since January of 2009. In fact, China can be seen moving backwards. It recently inaugurated a pilot program that will allow exporters to hold offshore accounts of foreign currency, which might be expected to relieve some of the upward pressure on both the Yuan and on China’s foreign exchange reserves: “If you don’t force firms to surrender their foreign-exchange proceeds, then they won’t be exchanged for renminbi, which is a source of appreciation pressure.” In this way, China can both limit speculative capital inflows (even by domestic investors) and inflation.

Foreign governments, led by the US, are still threatening action. Senators and Congressmen continue to harp on the issue (it is election season, after all), and are still threatening to slap a tariff on all Chinese imports. However, their efforts are being undermined by both the Department of Treasury (which refuses to label China a “currency manipulator”) and the Department of Commerce, which recently determined that the application of a broad-based tariff on all Chinese imports would violate its mandate.

I have always been cynical about China’s forex policy, on the basis that it is self-interested and disingenuous, and I think the fact that it remains pegged to the USD confirms that sentiment. In the end, China won’t bow to international pressure. It will only allow the Yuan to appreciate after it has determined that its economy won’t be negatively impacted, and even then, the pace will be glacial.

I concluded my last post (Euro Recovery: Paradigm Shift Confirmed) by musing about how interesting it is that nobody has taken credit for predicting/profiting from the sudden reversal in forex markets, whereby the Euro has surged and the Dollar has tanked. Two days later, I think I can offer an explanation: China.

That’s right. The force behind the sudden sea change might not be private investors, which up until the spike entrenched itself as a full-fledged connection, remained firmly behind the declining Euro. Instead, it seems quite reasonable that China – via its sovereign wealth fund, which is charged with investing its foreign exchange reserves – might be the responsible party.

That China is buoying the Euro would make sense on a couple fronts. First of all, it would explain the mysterious silence behind the rally. China is naturally secretive in pretty much everything it does, especially in the way it conducts currency policy and manages its forex reserves. That China hasn’t even formally announced, let alone bragged about, “diversifying” its reserves, makes perfect sense.

More importantly, that China is responsible also makes sense from a strategic standpoint. China has long spoken about its intentions to change the allocation of its forex reserve holdings, and in hindsight, its timing was perfect. In the beginning of June, the Euro stood at a multi-year low, and the price of US Treasury Bonds stood at a multi-year high. Thus, China’s sovereign wealth fund was able to simultaneously lock in some profits from lending to the US and dissipate risk by swapping US assets for those denominated in Euros and Yen. “China has already bought $20 billion worth of yen financial assets this year, almost five times as much as it did in the previous five years combined.” [Analysts have noted that buying Yen also achieves the peripheral end of making Japanese exports less competitive relative to those from China].

Moreover, China can achieve this diversification without influencing the value of the Yuan, since Dollars can be exchanged directly for Yen and Euros. That is important, since the RMB is still effectively pegged to the Dollar. Speaking of which, the Yuan has hardly budged since its 1% revaluation in June. On a trade-weighted basis, it has actually fallen.

Pressure continues to mount on China to allow the RMB to appreciate. As a result of the 1% nudge in June, speculative hot money is now flowing into China at an increasing rate, because investors are “thematically looking for ways that they can participate in the currency markets in China.” They are supported by the IMF, which most recently called on China to re-balance its economy away from exports and towards trade. Its report included predictions that China’s currency account / trade surplus will continue to rise, seemingly for as long as the RMB remains undervalued. Due to pressure from China, however, it removed precise figures on the recommended extent of said revaluation.

According to a consensus of analysts, China’s exports were probably lower in the month of July, which could give the Central Bank pause in allowing the RMB to rise too much too soon. Instead, it has announced that it will make a more sincere effort to tie the Yuan to a basket of currencies, rather than just the Dollar. ” ‘The yuan should be kept stable at a reasonable and balanced level overall, while it may have two-way moves against particular currencies,’ Hu [XiaoLian, Deputy Governor] said, adding that the composition of the central bank’s currency basket should be mainly based on trade weightings.”

Going forward, then, the Yuan will probably remain basically stable against the Dollar. As China moves towards a trade-weighted peg, however, it is conceivable that it will continue to buy Euros (and Yen, for spite) against the Dollar. As this could have a confounding effect on currency markets, traders should plan accordingly.

Today marks the one-month anniversary of China’s decision to remove the Yuan’s peg to the Dollar, and allow it to float. Now that the news has had a chance to wend its way through the financial markets, I think it’s time both to reflect and to forecast.

Over the last month, the Chinese RMB has appreciated by slightly less than 1% against the Dollar, although most of that jump took place in the day that followed the June 19 announcement. After the initial excitement faded, a sense of disappointment set in as it became clear that China had no intention of allowing the RMB to appreciate rapidly: “The subsequent appreciation of the yuan against the dollar is likely to be small, perhaps just a few percent over the remainder of the year.” In fact, futures prices reflect only an additional 1.5% appreciation over the next 12 months.

Due both to its slow speed and small scope, the revaluation could conceivably benefit the Chinese economy. That’s because in the short-term, a more expensive currency will mean higher prices paid for exports. The quantity of exports is unlikely to decline, such that total export revenues could actually increase. According to one analyst, “With Chinese imports, there are no substitutes in the short term. Maybe in 10 years, importers will have a choice, but right now they will just have to pay more. No other country…can build a manufacturing base and all the infrastructure that you need — transportation, energy, the entire value chain to the final good — takes many years.” As if on cue, China’s trade surplus expanded in June, in spite of the revaluation of the Yuan.

As a result, American manufacturers and other vested interests have announced that they will continue to lobbythe US government to pressure China on the currency issue, on the basis that the undervalued RMB is eroding both the US economy and the labor market. Argued the director of the Peterson Institute for International Economics, “The case for a substantial increase in the value of the renminbi is thus clear and overwhelming. An appreciation of 25% to 40% is needed to cut China’s global [account] surplus even to 3% to 4% of its GDP. This realignment would produce a reduction of $100 billion to $150 billion in the annual U.S. current account deficit.” It might also help to restore the estimated 1.4 million jobsthat have been lost due to China’s forex policy. According to analysts, however, political infighting make it unlikely that any new law or punitive tariffs will be imposed anytime soon.

At the very least, China will continue to make the Yuan more flexible, so that one day it can float freely. It has already moved to facilitate trade settlement in Yuan, and analysts expect ” ‘more than half of China’s total trade flows, primarily bilateral trade with emerging markets, to be settled in renminbi in the next three to five years.’ ” China is also making it more attractive for foreign investors to hold Yuan, by loosening controls that govern Chinese capital markets and creating new investment vehicles that will cater directly to foreigners. In the mean time, holding RMB is pretty unattractive given both “the hassle of getting money in and out of China” and the low rates offered by Chinese money market funds.

As for the impact on the rest of the forex market, I think that commodity currencies and growth currencies could come out ahead. The move signals an implicit confidence in the global economic recovery and can perhaps be seen as a harbinger for high commodity prices: In addition, it will “provide a boostto U.S. exports, employment, earnings and growth, reinforcing the case for growth sustainability at a time when investors are more fearful than they were in April.” The US Dollar, on the other hand, could emerge as one of the big losers. Already, China’s forex reserve growth has slowed to the weakest pace in 11 years. This trend will probably continue, since smaller purchases of Dollars will be required to maintain the floating peg. In fact, the Euro’s recovery against the Dollar has coincided mysteriously with the revaluation of the Yuan. While this is probably just a coincidence, it is nonetheless symptomatic of a declining role for the Dollar as the world’s reserve currency. But that is a topic for another day…

It was only last week that I mused about “Further Delays in RMB Revaluation.” Lo and behold, over the weekend, the Central Bank finally budged, by pledging to the members of the G20 that it would ” ‘proceed further with reform‘ of the exchange rate and ‘enhance’ flexibility.” Upon reading this, I suppose I should have felt stupid.

Still, I wondered whether the move was aimed as a political sop designed to appease Western countries, rather than a meaningful change in China’s forex policy. My suspicions were confirmed on Monday, when the markets opened, and the RMB jumped by a pathetic .4%. All of those who had been hoping for an expecting an instant revaluation a la the 5% jump in 2005 were sadly disappointed.

Most commentators shared my cynicism about the move. According to Goldman Sachs Group Chief Global Economist Jim O’Neill, ” ‘It’s pretty astute timing. The timing of it is clearly aimed at the G-20 meeting, which indirectly links to the whole renewed thrust in Congress with protectionist steps against China.’ ” If this was in fact China’s intention, it backfired, since it only succeeding only in bringing increased attention to the still-undervalued Yuan. Senator Sherrod Brown called the appreciation ” ‘a drop in a huge bucket….We’ve seen China take actions like this before when the spotlight is on, and then revert back to old tricks.” Thus, he and Senator Charles Schumer have announced that they will move forward with a bill to punish China, unless the RMB is allowed to significantly appreciate.

By the Central Bank of China’s own admission, this is unlikely. Instead, it will continue to “keep the renminbi exchange rate at a reasonable and balanced level of basic stability.” In other words, the RMB is still pegged squarely to the US Dollar. It is neither freely floating nor is it pegged to a basket of currencies (in which case it could conceivably appreciate faster against the Dollar, due to the weak Euro). It is technically allowed to rise and fall on a daily basis within a .5% ban, but even this is controlled tightly by the Central Bank, via the so-called Central Parity Rate. If the rate fluctuates too much, state-owned companies often intervene in the markets at the behest of the Central Bank. Legitimate market participants are heavily constrained by a rule that requires them to square all of their positions at the end of every trading session, such that making long-term bets on the RMB’s appreciation would be impossible.

Not that it matters. In the US, where it is legal to make long-term bets on the RMB (via futures contracts), investors are still only projecting a 1.8% appreciation (2.2% relative to the RMB’s pre-revaluation level) over the next year, and a 2.9% appreciation by the end of 2011. In the end, there just isn’t a lot of confidence that China will voluntarily act in a way that is contrary to its own short-term economic interests.

To be sure, there is a possibility that the RMB will be allowed to steadily appreciate, in which case there would be real implications for other financial markets. If the past is any consideration, however, the RMB will rise only modestly against the Dollar, and even more modestly on a trade-weighted basis. Its economy will remain overheated and imbalanced, and if it was headed towards collapse prior to this latest change, it certainly still is.

Throughout 2010, I have continuously reported on the apparent inevitability of the Chinese Yuan appreciation. That the currency still remains firmly fixed in place against the Dollar is a testament not only to the unpredictability of forex, but also to the doggedness of Chinese officials.

It seemed that China’s policymakers were all but set in February to allow the currency to resume its upward path (its appreciation was halted in 2008). If anything, the case for appreciation is stronger now than it was then. China’s economy grew by a blistering 11.9% in the first quarter. The bilateral trade surplus with the US has widened on the basis of strong export growth. Inflation has exploded, and there is a property bubble that refuses to cool.

Allowing the RMB to appreciate would cool China’s economy and presumably induce a moderation in inflation. In the short-term, it would lead to a slight expansion in the trade surplus (since prices would rise, but quantity would remain unchanged), but this would also moderate over the medium term. Decoupling from the Dollar would also enable China to pursue a more flexible monetary policy; in this case, that means raising interest rates to cool the property bubble as well as the economy at large. As Treasury Secretary Timothy Geithner himself has noted, ” ‘It’s in China’s interest to move.’ “

In the same speech, Secretary Geithner conceded that China is still dragging its heels: ” ‘I do not know if we are at the point now where we will see meaningful progress in the short-term.’ ” This inkling was confirmed by the Chinese Foreign Ministry, “China will reform its exchange-rate mechanism based on developments in the global economy and its own economic performance.” Chinese President Hu JinTao, meanwhile, has personally pledged to a visiting delegation from the US State Department to “continue reform of his country’s exchange-rate regime.”

This isn’t doing much to assuage American lawmakers, whom are currently being slighted by both sides. While China irks Congress by refusing to adjust the RMB, the Treasury Department is also irritating it by both refusing to label China a currency manipulator and by not establishing a deadline for appreciation. As a result, “There is a broad consensus in Congress for a simple proposition: ‘China is not acting in good faith and is aggressively engaged in a series of troubling and downright protectionist policies that put our economic relationship at risk.’ ” Finally, it seems that rhetoric will become reality, as a bill is currently being mulled that would aim to punish China (via punitive tariffs and WTO action) for failure to revalue.

Analysts are not optimistic. “The yuan’s 12-month non-deliverable forwards were at 6.7415 per dollar…reflecting bets for a 1.2 percent strengthening over that timeframe.” That’s down from expectations in April of a 3.5% appreciation. Some still believe that China will revalue in the third quarter, but there is no longer any force behind those predictions. Meanwhile, China continues to make long-term plans for its foreign exchange reserves, which indicates that it has no intention of unloading it as part of a controlled RMB appreciation. At this point, it’s essentially a game theory problem: when will China budge?

Even before the sovereign debt crisis in Europe damped confidence in the world’s second most important reserve currency, the Chinese Yuan was on the cusp of being accepted as a global reserve currency.

We’re all familiar with the arguments attacking the Yuan in this context: its currency is pegged, its capital controls are rigid, and its capital markets are shallow and illiquid. Say what you want about the world’s major currencies (volatile, debt-ridden, etc.), but at least none of these factors applies, goes this line of thinking. With the Euro’s future up in the air, however, a potential hole has been created in Central Banks’ respective forex reserves. As replacement(s) for the Euro are sought, such long-held assumptions are being challenged.

The Chinese Yuan is attractive for a number of reasons. First, investors and Central Banks want exposure to China’s economy; its average annual growth rate of 10% over the last 30 years is far-and-away the highest in the world. “China’s economic output will be more than $5 trillion, or around 9% of the world’s economy, according to the International Monetary Fund.” Second, the fact that the RMB is fixed is in some ways a perk: the wild fluctuations that most currencies witnessed as a result of the credit crisis has made some wonder if market-determined exchange rates aren’t overrated. Finally, the widespread consensus is that the RMB will appreciate anyway, so holding it seems like a safe bet.

Therefore, “Central banks or sovereign wealth funds from Malaysia, Norway and Singapore have received special quotas from the Chinese government to allow them to gain a bit of exposure to China’s currency. The bet is that holding yuan-denominated assets is an important feature of a diversified national reserve.” In addition, China has signed Yuan-denominated swap agreements with a handful of its most important trade partners, totaling $100 Billion over the last year.

Still, these are small-scale agreements, and Central Banks are really just testing the waters. According to a recent study by the Reserve Bank of India (RBI), “The Chinese yuan is ‘far from ready’ to gain reserve currency status. Rather, it said China’s yuan was likely first to become a regional currency as trade links with its neighbours expand.” The main issue is not one of stability, but rather of supply. Simply, there are not enough liquid, attractive investments, denominated in RMB. China’s stock and bond markets are filled with unreliable companies, whose primary loyalty is to the State, rather than to investors. Buying Chinese government bonds seems like a safe option, but given, that China finances most of its spending with cash, such bonds are not widely available.

For now, the Chinese Yuan will remain most attractive (from the standpoint of a reserve currency) to regional trade partners, because such countries have a genuine use for RMB. Investors seem to understand this idea, and are using the currencies of such countries to bet indirectly on the RMB. According to one analyst, “On days when trading is especially volatile, the Singapore dollar moves in tandem with the yuan bets. The Malaysian ringgit, Taiwanese dollar and Korean won are also high on the list of currencies affected by the yuan.” In short, the RBI’s assessment of the Yuan seems pretty apt. It will probably be at least a decade before holding the Yuan is as viable (not to say attractive) as the Japanese Yen. For investors who don’t want to wait that long, there are a handful of other regional currencies that they can hold in the interim.

Given that only a week has passed since the bailout of Greece was formally unveiled, it’s still too early to determine whether the plan will be success. Regardless of how it ultimately plays out, though, the bailout (not too mention the concomitant crisis) is shaping up to be THE big market mover of 2009. As investors reposition their chips, some early front-runners are emerging. It might surprise you that one such leader is the Japanese Yen.

On the surface, the Japanese Yen would seem to be an excellent candidate for shorting, especially in the context of the the Greek fiscal crisis. Its fiscal and economic fundamentals are abysmal, and by most measures, it’s debt position is among the least sustainable in the world, behind even Spain, Portugal, and the US. At the same time, the Yen has risen by an unbelievable 8% against the Euro in the last week alone, and many analysts are predicting it will emerge as one of the winners of this episode.

Why? First of all, with confidence in the Euro flagging, the Yen (and the Dollar) gain luster as the only viable reserve currencies. Regardless of what you think about Japan’s fiscal fundamentals, the longevity at the Yen means that it is inherently safer than the Euro, which may not even exist (in its current form, at least) in a few years time. Second, the current consensus is that the Euro bailout will fail, and as a result, risk tolerance is running low at the moment. With this in mind, it’s no surprise that traders are unwinding their carry trades and that the Yen – “The low-yielding currency of a deflation-prone economy of high savers…entrenched as the world’s funding currency” – has rallied.

Analysts have been quick to point out that the rest of Asia (among other regions) are on the other side of this trend. The concern is that the bailout won’t be enough to prevent a repeat credit crunch and that confidence in investments/currencies that are perceived as risky will remain low.

China could be hit especially hard. Since the Chinese Yuan is pegged to the Dollar (and even it wasn’t), it has risen by a whopping 15% against the EUro over the last six months, severely crimping exports to the EU. In addition, “Chinese exporters rely very heavily on bank letters of credit to finance their shipments…When banks have trouble borrowing money themselves — as has been happening as a result of worries about European banks’ possible losses from the region’s sovereign debt crisis — they tend to cut sharply the issuance of letters of credit for trade finance.” It’s no wonder that the Chinese stock market has tanked 21% so far in 2010, and that the Central Bank continues to delay revaluing the RMB.

Of course, if the plan turns out to be a success, than the opposite will probably obtain. “In this case…the currency of any emerging market or advanced economy exposed to the Asian region’s impressive, China-led economic growth,” will probably rally. “It could be the South Korean won, the Australian dollar, or the currencies of commodity-producing countries like Brazil.” The Japanese Yen, meanwhile, will probably be hit with a dose of reality, followed by a double dose of the carry trade.

There are no words to describe the size of China’s foreign exchange reserves. Massive, Mind-Boggling, and Eye-Popping come to mind, but don’t do the $2.447 Trillion justice. What’s more, this figure represents the end of March; the current total has almost certainly surpassed $2.5 Trillion.

Interesting, the rate of reserve accumulation has slowed markedly from 2009. In the first quarter of 2010, the reserves grew by “only” $45 Billion, compared to growth of $125 Billion in the fourth quarter of 2009. There are a couple key explanations for this slowing. First, China’s trade balance has narrowed considerably over the last twelve months, to the point that it in March, it recorded its first trade deficit in six years. Second, China tallies its reserve growth on a net basis – after accounting for changes in valuation. Given that the majority of China’s reserves are still denominated in US Dollars, then, the Dollar’s appreciation over the last quarter may have shaved $40 Billion from the accumulation of new reserves. With this in fact in mind, the actual slowdown is probably much less pronounced than the numbers would suggest.

Besides, exports and foreign direct investment both continue to grow at healthy clips, which means there is nothing (barring a revaluation of the RMB) which could significantly slow reserve accumulation going forward. Even with a revaluation (that many experts believe is imminent), the need to further accumulate reserves will not be impacted, because the RMB will certainly continue to be pegged to the US Dollar. In order to prevent price inflation (which is already creeping up) from reaching dangerously high levels, then, the government will have no choice but to continue to soak up all capital inflows for as long as the RMB remains pegged.

Speaking of revaluation, the unchecked growth of China’s forex reserves would seem to strengthen the case for it. As the WSJ analysis showed, the value of China’s portfolio of reserves has fluctuated wildly over the last five years due both to gyrations on the capital markets and volatility in forex markets. In fact, China has lost a massive $70 Billion due to such volatility since 2003. In short, this program of accumulating reserves is not only a massive headache, but also a losing proposition.

Experts estimate that more than 2/3 is still denominated in USD. Since the Chinese RMB is also pegged to the Dollar, that means that as the RMB appreciates against the Dollar, the value of its reserves will fall in local currency terms. Rectifying this problem is basically impossible, as the EU sovereign debt crisis has demonstrated. It has looked into the possibility of investing in alternative assets such as Gold, Oil, and other commodities but there is simply not enough global supply to soak up more than a small fraction of China’s $2.5 Trillion. For all of the problems with the Dollar, the alternatives are just as bad, if not worse. At this point, the best China can hope for is to “cut its losses” by revaluing sooner rather than later.

The hoopla surrounding the semi-annual release of the Treasury’s currency report has been awkwardly resolved. As a result of Chinese Prime Minister Hu Jintao’s last minute decision to participate in a US conference on nuclear disarmament, the Treasury has agreed to delay the release of the report for an indeterminate period.

While a handful of commentators saw this as a simple quid pro quo, the consensus among most of us is that a revaluation of the Chinese Yuan is now imminent. Technically, the RMB has been rising steadily for the last few months, and in fact, it recently touched a 9-month high against the USD. However, this appreciation has amounted to a mere .3%, certainly not enough to placate critics, many of whom insist that the RMB is undervalued by 25-40%. Probably within the next couple months (and as soon as tomorrow), the RMB peg will probably be lifted by at least 5% against the Dollar, and allowed to appreciate incrementally from there.

On the surface, it looks like President Obama deserves much of the credit for the sudden capitulation by China. From tire tariffs to a meeting with the Dalai Lama, he signaled that he was willing to play hard ball. As Senator Charles Schumer, one of the most vocal critics of China’s forex policy, said recently, “Every administration has thought it could get something done by talking to China. But years of experience have shown that the Chinese will not be moved by words; they only respond to tough action.”

While this game of high-stakes International Poker was being played, there was an internal debate taking place within China. On one side was the Central Bank, frustrated by its inability to conduct monetary policy independent of the currency peg. On the other side was the more powerful Commerce Ministry, which is responsible for representing the interests of Chinese exporters, among others. It appears that the Commerce Ministry has lost the debate, although it isn’t going down without a fight. After economic data showed the first monthly trade deficit ($7+ Billion) in 6 years, a press release argued that, “The continued improvement in our country’s balance of trade has created the conditions for the renminbi’s exchange rate to remain basically stable, case received a boost from the March $7 Billion trade deficit, the first monthly deficit in 6 years.”

At this point, analysts have stopped arguing about whether the revaluation is necessary (though this debate has not officially been resolved) and moved on to simply trying to predict the outcome of the internal Chinese negotiations. Some are skeptical:”Based on off-the-record briefing from officials in Beijing, one development that does not appear likely in the short term is any Chinese action to change the currency peg that ties the renminbi to the dollar.” However, this is contradicted by the prevailing view among China-watchers, which is that “Beijing will move on the currency not because they want to placate international pressure on trade flows but because domestic conditions suggest that such a move will be in their own interests.”

This is reflected in futures prices, which are now pricing in a 3% appreciation in the RMB by the end of the year, compared to expectations of a mere 1.5% appreciation in March. What’s harder to gauge (and speculate on) is how other currency pairs will be affected. Some analysts believe that an RMB appreciation will trigger a decline in the Euro, since China’s currency peg had also necessitated tangential purchases of Euros: “The euro will be more vulnerable from the perspective that the People’s Bank of China in the past diversified away from Treasuries to buy euro zone bonds.”

Asian currencies should also benefit, since a more expensive Yuan will trigger a marginal shift of (speculative) capital to regional competitors, especially those with undervalued currencies. In fact, the Bank of Korea is already on high alert for any “unusual” (code for sudden appreciation of the Won) activity in the forex markets, and has suggested that intervention is always a possibility.

As for me, well, I’m not taking any chances. I just transferred some of my savings from Dollars into Yuan (of course this wouldn’t really make sense if I didn’t live in China). I like to think of it as a rudimentary form of hedging.

Over the last couple weeks, rising expectations of a resumed appreciation of the Chinese Yuan (RMB) have brought heightened tension. Politicians, economists, and even newspaper columnists are finding themselves involved in increasingly bitter disputes over the issue. What’s more, the debate has regressed; whereas before it was a foregone conclusion that China would soon lift the peg and the only question was when, now people are once again asking themselves whether an RMB revaluation is even necessary/desirable.

Breaking with his old strategy (on multiple fronts, it should be noted) of soft speech and appeasement, President Obama is now openly calling on China to allow the RMB to appreciate: “Countries with external deficits need to save and export more. Countries with external surpluses need to boost consumption and domestic demand. As I’ve said before, China moving to a more market-oriented exchange rate would make an essential contribution to that global rebalancing effort.” While this would seem like a fairly mundane exhortation, it marks a strong break from Obama’s previous rhetorical approach, in which he generally avoided singling out China.

Meanwhile, the US Treasury Department is busy preparing its semi-annual report on foreign currencies, which will be presented to the US Congress on April 15. As usual, the media is focused on the portion concerning China, specifically with whether it is officially labelled a currency manipulator. Almost by definition, China manipulates the Yuan, but the Treasury Department has heretofore avoided the label because it would allow Congress to impose punitive trade sanctions. Ironically, the most pressure to bestow such a label is coming from Congress, itself.

Aside from the report, Congress is not sitting by idly, as evidenced by a recent letter to the President signed by 130 Representatives calling for action. The Senate is also busy with draft legislation that would place a 25-40% tariff on all imports from China unless the RMB is revalued by a similar percentage. “The senators said the U.S. recession could boost the political prospects for the legislation, which [Charles] Schumer has proposed in various forms since 2003. Schumer said the Senate proposal will be attached ‘very soon’ as an amendment to ‘must-pass legislation. The only way we will change them is by forcing them to change.’ ” Perhaps the economic recession has put things in perspective, and the legislation finally has the impetus needed to pass.

Chinese government officials continue to send conflicting signals. No less than China’s premier (the #2 man behind only the Prime Minister) Wen JiaBao, told reporters with a straight face that China doesn’t manipulate the Yuan and that in fact, it is other countries which are guilty of such a crime. Added another high-ranking official, “We don’t agree with politicising the renminbi [yuan] exchange rate issue.” On the other hand, Zhou XiaoChuan, head of the Central Bank of China “broke new ground by stating that exiting the stimulus would sooner or later spell the end of the ‘special yuan policy’ adopted to counter the financial crisis.” Evidently, the currency peg is interfering with the ability to conduct monetary policy, specifically by raising rates to fight inflation. As if the position of the government wasn’t muddled enough, the Ministry of Commerce is now running “stress-tests” on large exporters to see how they would fare in the event of a large revaluation.

Economists are also getting into the fray, with Nobel Laureate and NY Times columnist Paul Krugman editorializing that China’s Yuan policy “seriously damages the rest of the world. Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.” Morgan Stanley’s Chief Asia economist, Stephen Roach, reacted to this accusation by suggesting inexplicably that, “We should take out the baseball bat on Paul Krugman.” This set off a heated back-and-forth (conducted indirectly through other reporters) between the two economists, ultimately accomplishing nothing other than to bring added attention to the issue of the Yuan.

At this point, everyone – except for Stephen Roach and the WSJ editorial board – seems to agree that a revaluation would benefit everyone. “I basically think that making the yuan flexible would be positive, not only for the world’s economy, but also for China’s. Many of China’s neighbors seem to have questions about the dollar peg,” summarized a vice Finance Minister of Japan. Chinese officials accept and even share that view, and from their point of view, the revaluation is only a matter of being able to do so on their own terms. As with many things in China (coming from someone who lives there), it’s important to save face.

It’s still anyone’s guess as to if and when China will allow the Yuan (RMB) to continue appreciating. You can see from the chart below – which shows the trading history for the RMB/USD December 2010 futures contract – that expectations of revaluation have eroded steadily since December 2009. At that time, it was projected that that Yuan would finish 2009 at 6.57 RMB/USD, 4% higher than the current level. Fast forward to the present, and investors now only expect a modest 2% appreciation rise on the year.

What’s behind the change in expectations? The answer is a combination of economics and politics. On the economic side, China’s trade surplus is much smaller than in recent years, as import growth outpaces export growth. “Double-digit annual growth in exports is all but assured in coming months due to a low base of comparison in early 2009, but…sequential growth momentum went into reverse in January, with exports down 16 percent from December.” Moreover, while GDP growth appears strong, it appears tenuously connected to exports and fixed-asset investment. In addition, if the Central Bank of China raises interest rates to counter property speculation, it will have even less room to maneuver in its forex policy if it wishes to maintain high GDP growth. In terms of politics, the CCP doesn’t want to lose a crucial bargaining chip in international relations, and it also doesn’t want to mitigate the threat to its political legitimacy posed by a prolonged economic slowdown.

On the other hand, China still desires to turn the Yuan into a global reserve currency, again both for economic and political reasons. In order to accomplish such a feat, one of the prerequisites would be dual convertibility. Financial institutions and foreign Central Banks are still extremely reluctant to hold RMB currency since it’s difficult to convert into other currencies. “Citing data from the Bank of International Settlements (BIS), it [Citigroup] said the renminbi’s share in the global foreign-exchange market turnovers was only 0.25 percent in 2007, ranked 20th in the world and fifth among Asian emerging-market currencies.” This is pretty incredible considering that China’s economy is the world’s third largest, and will only change when the exchange rate regime is loosened.

While some analysts predict that the Yuan will continue rising as soon as next month – and at least by a slight margin for 2010 – the modest pace of appreciation will ensure that China’s foreign exchange reserves continue to grow. They are currently estimated at $2.4 Trillion, and while their composition is largely a secret, analysts estimate that more than 2/3 is denominated in USD-denominated assets. Recently, there was a perception that China had begun to diversify its reserves out of Dollars, as US Treasury data indicated that its Treasury purchases had all but stopped. As it turned out, China had merely moved to conceal its purchases by conducting them through a UK Bank.

The biggest threat to the USD posed by China is not an end to the RMB peg – for such is unlikely – but rather a change in its structure. Currently, the RMB is pegged directly to the Dollar, which means that the Bank of China MUST stockpile its trade surplus in USD-denominated assets, namely US Treasury securities. If the peg were to shifted to a basket of currencies, however, it would have more flexibility in the denomination of its reserves. Until then, China’s forex policy will continue to favor the Dollar.

Last month, I reported on how anticipation is (was) building towards a revaluation of the Chinese Yuan (RMB), confidently stating that “The only questions are when, how and to what extent.” While I’m not ready to recant that prediction just yet, I may have to temper it somewhat.

On the one hand, the case for RMB revaluation is stronger than ever. Among large economies, China’s economy is by far the strongest in the world, clocking in GDP of close to 2009% while most other economies were lucky to “break even.” Meanwhile, its export sector – supporting which is the primary purpose of the RMB peg – is once again robust, having recovered almost completely from a drop-off in demand in 2008 and the first half of 2009. In fact, exports grew by 30% in January, on a year-over-year basis. China’s share of global exports is now an impressive 9%, up from only 7% in 2006. From an economic standpoint, then, the case for an artificially cheap currency is no longer easy to make.

At the same time, the RMB peg is contributing to bubbles in property and other asset markets. That’s because the Central Bank of China has been forced to mirror the monetary policy of the Fed, as a significant interest rate differential would stimulate uncontrollable capital inflows from yield-hungry investors. While the US can still handle interest rates of close to 0%, China’s economy clearly can not. Thus, consumer prices are slowly creeping up, and property prices are soaring. The most effective (and perhaps the only) way for China to contain both consumer price and asset price inflation is to hike interest rates, which which in turn, would necessitate a rise in the RMB.

There is also the notion that the peg is becoming increasingly costly to maintain. China’s forex reserves already total $2.4 Trillion, and each Dollar that it adds will be worth less if/when it ultimately allows the RMB to appreciate further. In addition, China’s economic policymakers continue to fret about its exposure to the fiscal problems of the US, with one pointing out that, “China has effectively been kidnapped by U.S. debt.” Of course, they no doubt realize that there isn’t a better option at this point; its attempt to diversify its reserves into other assets proved disastrous. The solution to both of these problems, of course, would simply be to allow the Yuan to fluctuate based on market forces, or at least for it to resume its upward path of appreciation.

Political pressure on China to revalue, meanwhile, is even stronger than it was last month. While not invoking China by name, President Obama has been increasingly blunt about the need to pressure it on the RMB: “One of the challenges that we’ve got to address internationally is currency rates and how they match up to make sure that our goods are not artificially inflated in price and their goods are artificially deflated in price.” In addition, rumor has it that the Treasury Department could finally label China as a “currency manipulator” in its next report, which would allow Congress to impose punitive trade sanctions.

Developing countries, which now account for a majority of China’s exports, are also increasingly unhappy with the status quo. The peg to the Dollar caused many emerging market currencies to appreciate rapidly against the Yuan in 2009, and there is evidence that many of their trade imbalances with China are rapidly worsening, “with exports to India, Brazil, Indonesia and Mexico growing by 30% to 50% in recent months.” As one analyst pointed out, however, the potential backlash from this development could be massive: “It’s one thing to produce job losses in the U.S., but it’s another to produce job losses in Pakistan,’ with which China has close military ties.”

On the other hand, however, is China’s massive reluctance to allow the Yuan to appreciate. Part of this is related to face; with the US and other countries stepping up pressure on a number of fronts, China’s leaders don’t want to be seen as weak, and could act contrary to their own interests if it thinks it can earn political points in the process. “China is unlikely to make significant concessions to U.S. pressure on the yuan, particularly now when the two countries are involved in a range of disputes, including U.S. arms sales to Taiwan,” explained one analyst. More importantly, the leadership is nervous that the nascent economic recovery is not sufficiently grounded for the peg to be loosened. While 9% growth in most other economies would be cause for celebration, in China, it is being interpreted as evidence of fragility.

There you have it. Reason on one side, and politics on the other. Unfortunately, it seems that politics always triumphs in the end. Despite Treasury Secretary Geithner’s recent assertions that the RMB will rise soon, investors know that China ultimately calls the shots: “When it comes to the exchange rate, China’s main consideration is China’s own stable economic growth and the structural adjustment of its economy. Foreign pressure is only a secondary consideration.” In short, the RMB is now projected to appreciate only 2% in 2010, according to currency futures, compared to 3.5% last month.

The Chinese Yuan (RMB) spent all of 2009 pegged to the Dollar at 6.83. Since the Dollar depreciated against almost every other currency during that time period, the Yuan has fallen against these currencies, undoing most of its appreciation in 2008. As a result of both international pressure and internal economic conditions, however, the Yuan’s stasis should come to an end soon. The only questions are when, how and to what extent.

In hindsight, the Central Bank (i.e. state economic planners) of China were probably justified in holding the Yuan in 2008. At a time when forex markets (and other capital markets, for that matter) were behaving erratically, the Yuan was a baston of stability. China’s premier, Wen Jiabao, recently boasted, “Keeping the yuan’s value basically steady is our contribution to the international community at a time when the world’s major currencies have been devalued.” In fact, there is evidence that the Central Bank went against market forces in the opposite direction during the height of the credit crisis, and successfully prevented the Yuan from depreciating, thus proving that a currency peg can work both ways. The result was price stability, and a boost to exporters that had been damaged by the falloff in foreign demand for Chinese goods.

With the global economy emerging from recession, the argument for maintaining the peg is becoming less tenable. China’s economy, itself, grew at an impressive 8.5% in 2009, and is forecast to grow even faster in 2010, by 9.5%. Thanks to a surge in bank lending and the government’s massive economic stimulus program, inflation is also ticking up. It has been approximated at 2.5%, but is contradicted by spikes of 50%+ in the prices of certain staple goods, and certainly doesn’t take into account the rise in asset prices. China’s benchmark stock market index surged 90% in 2009, and property prices increased by 30% in some areas.

The dual concerns, of course, are that the money supply is expanding too fast and that bubbles are forming in certain asset markets. The weak RMB is certainly not helping either. Thanks to relaxed capital market controls and expectations of further appreciation, speculative “hot money” is once again pouring into China. Holding down the Yuan in the face of such pressure is becoming prohibitivel expensive: “China’s foreign-exchange reserves climbed 17 percent in the first nine months of 2009 to $2.27 trillion, the world’s largest holdings.” Some of the demand is naturally being tempered by bubble concerns, but the trend is still money coming into China.

There is also the argument, much mooted in economics circles, that an appreciation of the RMB would be good for the Chinese economy. Because of a perennially weak currency, its economy has become to addicted to exports to drive growth. “As a report from research firm Euromonitor International notes, in U.S. dollar terms, China’s consumer market lags those of the U.S., Japan and much of Europe, with private consumption just over one third of GDP in 2008.” This is probably a product of social and cultural forces, which still emphasize saving. Skeptics of the usefulnes of RMB appreciation point out that rebalancing the Chinese economy would start with changing the culture of saving, but a stronger currency would certainly provide a powerful incentive. Not to mention that a more valuable RMB would give Chinese companies more leverage in consummating outbound corporate M&A deals and natural resource acquisitions that they have been so keen on in recent years.

On the other side of the debate are skeptics of a different sort- those that think RMB appreciation is justified by forward-looking macroeconomic fundamentals. Some fear hyperinflation of the sort that China faced in 2007 and was only brought under control by the global economic recession and concomitant decline in resource prices. “Franklin Allen, a professor of finance at Wharton [University of Pennsylvania], estimates the likelihood of inflation reaching between 10% and 20% to be around one in five.” Any inflation beyond what is experienced in other economies would have to be reflected in the RMB. In a hyperinflation scenario, the Central Bank might even have to deliberately depreciate the currency.

Then there are the skeptics that forecast an economic crash in China. James Chanos, a wealthy hedge fund manager is leading this chorus, “warning that China’s hyperstimulated economy is headed for a crash, rather than the sustained boom that most economists predict. Its surging real estate sector, buoyed by a flood of speculative capital, looks like “Dubai times 1,000 — or worse.’ ”

While this view is gaining some traction, it is still relegated to the minority. Investors and economists are now operating under the firm assumption that China will allow the RMB to resume its appreciation soon. As for when, it could be any day, though probably not for a few months still. As for the questions of how and to what extent, some economists have argued for a one-off appreciation (10% has been suggested) in order to discourage future inflows of speculative capital. Most analysts, though, expect the rise to be gradual. Futures prices currently reflect a 3% rise over the next year, and the consensus among economists is similar. It also depends on how the Dollar performs over the near-term: “If better-than-expected growth in the U.S. helps the greenback recover this year…That would take some of the pressure off Chinese policy makers.”

Personally, I think expectations of a 3-4% rise over the next twelve months are pretty reasonable. The Chinese government doesn’t have much to gain (neither politically nor economically) from a rapid appreciation in the currency, so if/when the RMB rises, it will probably only be in “baby steps.”

Subtle title, right? I couldn’t resist, considering that literally all economists and government officials (outside of China, of course) have sounded off on the Chinese Yuan in the last month. Recent additions to this list include President Obama, Chiefs of the IMF and World Bank, President of the Asian Development Bank, US Commerce Secretary Locke and Treasury Secretary Geithner, Nobel Laureate Paul Krugman, ECB Chief Jeane-Claude Trichet, Harvard University Professor Martin Feldstein, Japan’s finance minister…not to mention the thousands of others that didn’t make international news for their denunciation of China’s currency policy.

This rhetoric has also been accompanied by several important developments, including a Presidential visit to China, several meeting of the G20, a summit in Singapore, a slight change in the wording of China’s forex strategy, the release of economic data that suggest China’s economy is strengthening, etc. At the same time, their remains an obstinate insistence from every corner of the CCP that despite this pressure, there are no imminent plans to further revalue. Investors are erring on the side of appreciation, however, and futures prices reflect a 3.5% rise in the value of the RMB over the next 12 months.

This disconnect is indicative of the fact that there is both a political and an economic side to this issue. When examined exclusively from either side, it looks like pretty cut-and-dried, since economics suggests that a revaluation is both necessary and desirable, but the misalignment of political interests suggests that it won’t be carried out any time soon.

More specifically, a chorus of economists (backed by hard data) is arguing that the RMB is one of the foremost causes of the widening imbalances. After a brief hiccup, China’s trade surplus is once again expanding, and is on pace to reach $300 Bill ion in 2009, more than half of which can be attributed to the US. Meanwhile, while GDP is projected at 10.5%, the rest of the world is still sputtering along. “China is ‘stealing’ jobs from developing countries and hindering a global recovery by keeping the yuan low, Nobel laureate Paul Krugman says. ‘China’s bad behavior is posing a growing threat to the rest of the world economy.’ ”

Economists also argue that a revaluation would also be in China’s own best interest. Foreign capital is now pouring into China at a record pace – largely in anticipation of an imminent appreciation in the Yuan – such that asset prices have almost doubled over the last year. “Risks of asset-price bubbles and misallocation of resources amidst abundant liquidity need to be addressed,” said the Chief Economist from the World Bank. Echoed the head of the IMF: “An undervalued currency encourages companies to invest in ways that may not be viable once the currency rises. ‘If you have wrong prices, you make wrong decisions, especially concerning investment in the long run.’ ”

Foreign politicians, especially those from the US, have been hammering these points home. President Obama made the RMB a key issue during his visit to China this week. Senator Chris Dodd chimed in with his two cents, that “You can’t give your competitor, your adversary in this case, a 40 percent advantage in global economies.” As analysts pointed out, the US, unfortunately, doesn’t have any leverage on this issue, as it is basically dependent on China to fund its budget deficits through Treasury Purchases. Thus, Chinese Prime Minister Hu JinTao couldn’t even be bothered as to so much mention the RMB when summarized the meeting with Obama for reporters.

Other Chinese Ministers rebuffed reporters in separate sessions who even dared to bring up the RMB: “Any policy changes by China, including on the exchange rate, will be based on its assessment of its own interests, not on external pressure.” Meanwhile, “Chinese officials refused to sanction a statement at the Asia Pacific Economic Co-operation summit in Singapore that would have pressed it to adopt ‘market-oriented’ exchange rates for the yuan.” In fact, they have begun to push back against criticism, by arguing that a weak Yuan has actually been economically beneficial. “China keeping a basically stable exchange-rate policy is, in reality, good for the global economic recovery,” argued the Minister of Commerce .

This political/economic dichotomy is also evident within China. The Central Bank recently changed some of the language which governs its forex policy; going forward, the Yuan will apparently be tied to a basket of currencies, with its value also influenced by trends in capital flows. However, “The central bank’s position is getting a determined push-back from manufacturers and exporters especially along China’s wealthy coast who stand to reap significant gains in the short term.” Given that the decision to lift the RMB will ultimately be made in the political arena, it’s understandable that the latter group has such a strong bearing on the process.

As I indicated above, investors are cautiously optimistic that the government will eventually relent to its critics and allow the currency to resume its steady upward path. Futures prices have risen steadily since September, when they reflected a flat RMB over the next twelve months. According to one analyst, ” Officials may, starting in the second half of 2010, allow it to recoup the drop of about 10 percent on a trade-weighted basis it’s had since March.” Goldman Sachs, long respected for its economic forecasts, remains one of the lone naysayers, arguing that the Yuan isn’t going anywhere until at least 2011.

Personally, my money is an appreciation in the near-term, as soon as the first quarter of 2010. Chinese leaders are stubborn, but they aren’t stupid. It won’t be pressure from the US that will shake them from their moorings – but a further inflation of property and stock market bubbles and concerns over the economy’s unhealthy dependence on exports for growth.

The Economist recently published a special report on China and America (“Round and round it goes“). As the title suggests, the article described the increasing interdependency between the economies of the US and China. In a nutshell, China maintains an undervalued currency, in order to stimulate exports. The resulting overseas (American) demand puts upward pressure on the RMB, which China defuses by buying US Treasury securities. This results in artificially low US interest rates, causing American consumers to import more, putting even more pressure on the RMB, which is further defused by buying more US Treasuries. And the cycle continues ad nauseum.

The article focused primarily on the political side of this precarious relationship, at the expense of the financial implications. It got me thinking about the forex forces at work, and how a disruption in the cycle could have tremendous ramifications for currency markets. It’s clear that in its current form, this system keeps the Yuan artificially low, but does that means that the Dollar is also being kept artificially high.

Given the depreciation of the Dollar over the last six months, this seems almost hard to believe. Over the same time period, though, China (as well as many other Central Banks) have vastly increased their Treasury holdings. This would seem to imply that indeed, the Dollar’s fall has been slowed to some extent by the actions of China. It’s kind of a paradox; as US consumers recover their appetite for Chinese goods, the Dollar should decline. But as China responds by plowing all of those Dollars back into the US, then the net effect is zero.

As the Economist article intimated, there are a couple of developments that would seem to upset this equilibrium. The first would be if the Central Bank of China began diversifying its forex reserves into other currencies. By definition, however, it would be impossible for China to continue pegging the RMB to the Dollar without simultaneously buying Dollars. Thus, the day that China stops recycling its export proceeds into the US, the RMB would start to appreciate, almost instantaneously. In addition, the sudden surcease in US Treasury bond purchases would cause interest rates to rise. Both higher rates and a more expensive currency would presumably result in lower demand for Chinese exports, and hence eliminate some of the need to recycle its trade surplus back into the US. In this way, we can see that China’s Treasury purchases are actually self-fulfilling. The sooner it stops purchasing them, the sooner it will no longer need to purchase them.

I’m tempted to elaborate further on this point, but it seems that I’ve already taken it to its logical conclusion. China must recognize the dilemma that it faces, which is why it refuses to break from the status quo. If it allows the Yuan to appreciate, it will naturally face a decline in exports AND the relative value of its US Treasury holdings will decline in RMB terms. Both would be painful in the short-run. However, by refusing to concede the un-sustainability of its forex/economic policy, China is merely forestalling the inevitable. With every passing day, the adjustment will only become more painful.

In its semi-annual report to Congress, the Treasury Department once again failed to officially label China (or any country for that matter) a currency manipulator. No surprise there. While it’s self-evident that China manipulates the RMB (via the peg with the US Dollar), the political implications of such a label prevent it from being used except in the most extreme cases. Nonetheless, there is mounting pressure on China, both domestic and international, to “adjust” the peg and allow the Yuan to move closer to its fundamental value.

Most of the international pressure has been soft, coming in the form of roundabout pleas for China to allow the Yuan to float “for the sake of global stability.” Said one US Senator weakly, “I hope that with strong leadership from the United States, the G-20 nations and our international institutions will undertake what has been missing — a focused, sustained and meaningful multilateral engagement to address currency manipulation and current imbalances.” At the same time, some of this rhetoric has recently been translated into action. Last month, the Obama Administration enacted a 35% tariff on Chinese tire products. Other countries have also begun to raise concerns about Chinese dumping, and bringing their cases to the WTO for good measure.

Many of these countries are in fact suffering more than the US. Since the Yuan is effectively pegged to the Dollar, the decline of the latter has been mirrored by the former. Since many other currencies of developing countries are also fixed, this leaves only a handful to absorb the shock. For example, the Euro and Yen have both risen about 15% against the RMB over the last year, in line with their appreciation against the Dollar. The handful of floating currencies in the region, such as the Korean Won, Indian Rupee, Malaysian Ringhit, etc. have also faced strong upward pressure. For them, it is not so much the weak Dollar that they fear so much as the weak RMB, since China is a direct competitor to all of them.

More importantly, there are now voices within China’s ruling Communist party that have also begun to press for a stronger Yuan. The Nationalist camp, for example, is pressing for China to make the Yuan a more prominent currency on the international trade scene. While such doesn’t inherently require a floating currency (in fact, all of the trade/swap agreements involving Yuan are based on fixed exchange rates), a loosening of capital controls and liberalizing of financial markets would probably bring about a stronger Yuan.

The other group pushing for a stronger Yuan is doing so on more fundamental, economic grounds. Just-released 2009 Q2 GDP data showed prelimenary growth estimates of a whopping 8.9%! Not bad, especially when you consider that the rest of the world remains mired in recession. Chinese economists largely ignore the political implications of the notion that this growth probably came at the expense of the rest of the world, and focus instead on the economc implications.

First is that the economy remains hopeless dependent on exports to drive growth, which can only be remedid through a stronger Yuan. Second, it heralds the coming of inflation. Many foreigners continue to pour “hot money” into Chinese asset markets hoping to reap the upside from both asset and currency appreciation. In response, “Analysts say China could let the yuan appreciate to help restrain inflation, since a stronger yuan would reduce the cost of imports. But some caution that Beijing tried a similar strategy in early 2008, but didn’t achieve great success in containing inflation or stemming the inflows.”

While analysts don’t expect the Bank of China to allow the RMB to rise until after the Chinese New Year in January, investors are pricing in incremental appreciation every month beginning with the next. In fact, futures prices already reflect the expectation that the RMB will rise 3% over the next twelve-months. My bet is that this will be kicked off by another one-off appreciation, in the same vein as July 2005. Now as was the case then, China needs to make up for lost time.

I concluded my last post by promising to discuss the implications of a change in the status quo, regarding the Dollar’s role as the world’s reserve currency. As it turns out, the last few days have witnessed a few developments on this front.

First of all, the G7 concluded its latest round of talks. Despite previous indications to the contrary, the organization continued its practice of releasing a communique. in which it noted that global economic balances persist and that policymakers should work together to mitigate them. While seemingly benign and desirable, the proposition couldn’t have come at a worse time for the Dollar.

The only reason why the Dollar hasn’t collapsed completely is because economies largely continue to recycle their surplus wealth and trade surpluses back into Dollar-denominated assets. One columnist connects the dots with regard to the forex implications: “Less Chinese intervention to prevent yuan strength would mean China, slowly over time, would build up fewer dollar reserves.” In other words, economies no longer concerned with pegging their currencies would have very little reason to build up large pools of reserves.

In fact, China is fully on board with this notion. Following the G7 talks, Chinese officials announced that it would support a stronger Yuan as soon as the global economic crisis resolved itself. By its own reckoning, this would facilitate a shift in its economy, from one dependent on exports for growth to one focused around domestic consumption. Still, obstacles remain, and “It is far from clear how China can engineer a shift up for the yuan against the dollar, which analysts note would almost certainly translate into a gain against other currencies as well.”

Speaking of China, it is also among the most vocal of nations laboring for alternatives to the Dollar. Towards this end, it has reportedly formed a secret coalition with the other BRIC countries (Brazil, India, and Russia), as well as Japan. The goal is to end the pricing of oil in Dollars by 2018. That the group has given itself nine years to complete this task speaks to its extraordinary ambition.

The implications for the Dollar cannot be understated. A handful of oil-producing nations in the Middle East hold a combined $2.1 Trillion in Dollars, which are solely a product of selling oil in exchange for Dollars. Already, the government of Iran has mandated that in the future, all of its reserves be held in non-Dollar-denominated assets. Thus far, no other countries have followed suit. China is aware that pushing for further developments could roil the US, which would be unlikely to sit on the sidelines and watch its currency be summarily jettisoned. “Sun Bigan, China’s former special envoy to the Middle East, has warned there is a risk of deepening divisions between China and the US over influence and oil in the Middle East.”

Robert Zoellick, president of the World Bank, doesn’t harbor any illusions, and announced during a recent speech that the a decline in the role of the Dollar is inevitable. “He said the United States ‘would be mistaken to take for granted the dollar’s place as the world’s predominant currency. Looking forward there will increasingly be other options to the dollar,’ ” such as the Chinese Yuan and the Euro.

Zoellick’s warnings were prescient, when you consider that the IMF just announced that the share of Dollars in global foreign exchange reserves declined significantly in the most recent quarter, perhaps to its lowest share since the Euro was introduced in 1999. [The latter, however, has yet to be confirmed]. “The dollar’s share in global reserves declined to 62.8% from 65.0%…The euro’s share increased to 27.5% from 25.9%.”

JP Morgan’s research team has discovered a similar trend- that accumulation of US assets accounts for only half of the global increase in global forex reserves. “Quantifying this trend is always imprecise. But the circumstantial evidence — official buying of U.S. assets runs at only half of the pace of global reserve accumulation — suggests that diversification has accelerated since June.”

So, there you have it. The Dollar’s demise (to borrow a characterization by one of the columnists featured in this post) is no longer theoretical. It may have already begun…

By now, the notion that the nascent global economic recovery is being and will continue to be led by China has become cliche. The NY Times summarized: “In past global slowdowns, the United States invariably led the way out, followed by Europe and the rest of the world. But for the first time, the catalyst is coming from China and the rest of Asia, where resurgent economies are helping the still-shaky West recover from the deepest recession since World War II.”

The statistics are certainly compelling. After a brief dip in the first quarter, GDP grew by an impressive 7.9% in the second quarter. In hindsight, the downturn in Chinese economic output was so slight as to hardly warrant use of the term recession to describe it; any other country would have rejoiced after achieving 6.1% (2009 Q1) growth, especially in the context of the current economic climate.

While stock market investors are evidently optimistic that the economy will continue to gather momentum, China-watchers and policymakers are more cautious. Wen Jiabao, premier of China, insisted that, “We must clearly see that the foundations of the recovery are not stable, not solidified and not balanced. We cannot be blindly optimistic.”

Wen’s downbeat prognosis should be seen in the context of China’s massive stimulus plan, which delivered an immediate jolt to the economy, but is already winding down. “The flood of bank lending in the first half of this year — equivalent to more than half of gross domestic product in the period…is ebbing. Net new lending in July was 355.9 billion yuan ($52.13 billion), the lowest figure so far this year and well below the first half’s monthly average of 1.2 trillion yuan.” Some analysts believe that this sudden decrease is due to seasonal factors, but others argue that it is a sign that the boost in lending (and spending) from the stimulus may have already exhausted itself.

In addition, the stimulus itself was not necessarily geared towards sustainable growth (in the economic, not the environmental sense). Over the last two decades, China embraced an economic model focused around exports and capital investments, at the expense of domestic consumption. While it will certainly be years before economists can determine whether the recession changed the structure of China’s economy, the earliest indications point to business as usual. “This year the bulk of the government’s stimulus is going into infrastructure, further swelling investment’s share. Chinese capital spending could exceed that in America for the first time, while its consumer spending will be only one-sixth as large.”

To be sure, the government has rolled out incentives and subsidies designed to reduce savings and increase consumption. However, Chinese cultural mores and the government’s lack of social services represent a formidable obstacle to any opening-up of the mentality of Chinese consumers- and their wallets. In fact, while China’s government is still nominally Communist, spending on public services is among the lowest in the developed world. Despite doubling to 6% of GDP, such spending is still well below the OECD average of 25%. The widening rich-poor gap, meanwhile, suggests that most of the windfall from China’s economic boon has been bestowed upon a relative handful of businesses and people, such that the majority of China’s 1.3 Billion populace simply doesn’t have the means to increase consumption.

For better or worse, the global economic downturn has severely crimped demand for Chinese exports, and this component of GDP could remain depressed for quite some time. After a record $400 Billion in 2008, the trade surplus plummeted in 2009, “to $35 billion in the same [second] quarter, 40% down on a year earlier…the decline is even more impressive in real terms (adjusting for changes in export and import prices), with the surplus shrinking to less than one-third of its level a year ago.” In fact, some analysts project that China could soon experience a trade deficit, if current trends continue.

All of this suggests that the Chinese RMB is not likely to return to its path of rapid appreciation (28% in real terms), observed from 2005-2008. (The currency has essentially been fixed at 6.83 RMB/USD since December 2008, leading to an 8% decline in real terms to match the decline of the Dollar.) China’s foreign exchange reserves, which have come to mirror the appreciation of its currency, are once again expanding. ($2.13 Trillion at last count). Given the decline in the trade balance and the explosion in the budget deficit, however, much of this increase must be attributed to the inflow of speculative capital, which will not necessarily translate into currency appreciation.

Some economists insist that the Yuan is still undervalued by as much as 25%, but investors don’t believe that it will bridge this gap anytime soon. While the spot exchange rate has risen to the strongest level since May, futures prices indicate a modest 1.5% appreciation against the Dollar over the next twelve months. This is an improvement from expectations of a flat exchange rate, but still a long way away from what some economists think is reasonable.

After a brief pause, China’s foreign exchange reserves have resumed their blistering pace of growth: “The reserves rose a record $178 billion in the second quarter to $2.132 trillion, the People’s Bank of China said today on its Web site. That dwarfs a $7.7 billion gain in the previous three months.” Considering that the global economy remains embroiled in the worst recession in decades, this is frankly incredible. [Chart below courtesy of WSJ].

As far as currency traders are concerned, this development has two important implications, the first of which concerns the Chinese Yuan (also known as RenMinBi or RMB). A quick parsing of trade and capital flows data reveals that the majority of the $178 Billion came from unconventional sources. “The trade surplus was $34.8 billion in the second quarter and foreign direct investment was $21.2 billion.” Currency fluctuations (i.e. the depreciation in the Dollar relative to other major currencies) can explain a small portion, “leaving the bulk of the increase in the reserves unaccounted for.”

In short, most of the capital now flowing into China is so-called “hot money,” chasing a piece of the action in China’s surging property and stock markets. The benchmark stock index has risen 75% this year, making it the world’s best performer. In short, China is once again “caught in a squeeze similar to the one that bedevilled policymakers earlier this century, with a flood of hot money trying to force the government’s hand on the currency.” Either it allows the RMB to resume its upward path against the Dollar, or it raises interest rates rapidly to head off inflation. With the money supply now growing at an annualized rate of 30%+, the government is running out of time on this front.

The second implication concerns the composition of China’s reserves. You can recall that in recent months, Chinese officials have become more vocal about ending the Dollar’s role as the world’s reserve currency, and have even taken token steps towards achieving that goal. But the latest analysis suggests that when push comes to shove, China is still firmly behind the Dollar: “Estimates suggest around 65% of China’s official holdings are in U.S. dollar assets, and the remainder are denominated in euro, yen, sterling and other currencies. This mix has been relatively stable as the Chinese government continues to place the bulk of its reserves in U.S. Treasury securities.”

In fact, “stable” is an understatement. While other Central Banks are gradually paring their holdings of US Treasuries, China is adding to its own stockpile. Already the world’s largest holder of Treasuries, China added another $38 billion in May, for a total of $800 Billion. “On the contrary, Japan, Russia and Canada were sellers of US assets in May. Japan, the second-biggest international investor, reduced its total holdings by $8.7 billion to $677.2 billion.” Meanwhile, Zhou XiaoChuan, governor of China’s Central Bank has endorsed the current composition of reserves: “Despite the $800 billion in U.S. Treasuries, it is a diversified portfolio overall.” This certainly represents a step backwards for Mr. Zhou, who only a couple months ago was leading the charge for a global reserve currency.

Perhaps over the longer-term, it can begin to take steps to dislodge the Dollar, but for now, it appears that China has accepted the status quo. As one analyst observed, “We do expect China to increase its purchase of gold and other commodities over time, but these markets are just not big enough to make a meaningful dent in the structure of the overall FX holdings. For example, if China decided to hold 5 percent of its current $2 trillion reserves in gold, it would need to buy …the equivalent to about one year of world production. For other hard commodities, the cost of storage is high and prices fluctuate wildly.”

China did recently appoint a new official (an economist trained in the US) to manage its reserves. “The move isn’t likely to fluster foreign-exchange markets or herald any change in China’s exchange-rate policy and reform.” Still, Chinawatchers are advised to continue to monitor the situation closely for any signs of discontinuity.

I toyed with today’s headline for a while, given that an equally cogent case could be made for either “Chinese Yuan Poised for Significant Appreciation” or “Chinese Yuan Poised for Stability.” Let’s face it- when it comes to to the Chinese Yuan, it’s a complete guessing game, since you’re not only dealing with the normal factors that affect currencies, but also with the whims of China’s Central Bank. Still, I think that the Yuan will continue to appreciate slowly and steadily, because such is in the best interest of China.

For the sake of context, consider that the Central Bank has held the Yuan around $6.83 for the better part of a year now, since the advent of the credit crisis. Prior to that, it had appreciated nearly 20% over the previous three years. The reason China has been able to get away with holding the Yuan constant for such a long period of time is the collapse in its trade surplus. Meanwhile, inflation has abated, down from a high of 7% to the current level of near 0%. As a result, the Central Bank can now have its cake and eat it to, by holding the Yuan constant without worrying about the effect on prices.

The most recent forecasts, however, suggest this is about to change. According to the World Bank, “China’s current-account surplus is likely to reach $388 billion in 2009…while foreign-exchange reserves will likely rise by $218 billion to $2.168 trillion at the end of this year.” Depending on who you ask, China’s economy is on track to grow by 7.2% to 7.5% in 2009, and by 8.5% in 2010. These forecasts represent upward revisions, and “Private economists have also been upgrading their outlook for China’s economic growth this year in the past couple of months since some major indicators including fixed-asset investment and industrial output growth have shown signs of improvement.” Second-Quarter GDP is scheduled for release in the next week, at which point we will likely see another round of revisions.

If such growth materializes, this would place China in a dilemma, such that it would have to choose between higher prices or more expensive currency. According to the Royal Bank of Scotland, “Policy makers will keep benchmark interest rates on hold this year because of declining consumer prices,” which implies, “The yuan will strengthen to 6.7 by the end of 2009 and 6.5 a year later.” Chinese Premier Wen JiaoBao agrees that “China should stick to an appropriately loose monetary stance and an active fiscal policy.” This notion is also reflected in futures prices, which have priced in a modest 1-2% rise in the Yuan over the next year [compared to previous expectations of a 5% decrease].

Economics aside, there is another major reason why the Yuan should continue to appreciate. China has been clamoring for several months now for a decline in the Dollar’s role as the world’s reserve currency, and a commensurate rise in the Yuan. Already, the country has started to take steps to increase the use of Yuan in settling cross-border trade, and “HSBC predicts that by 2012 nearly $2 trillion of annual trade (over 40% of China’s total) could be settled in yuan, making it one of the top three currencies in global trade.”

Still, the currency is still nowhere near satisfying the requisite convertibility inherent in reserve currencies. According to one analyst, “China would need to scrap capital controls so foreigners could invest in yuan assets and then freely repatriate their capital and income, but the government is wary of moving too quickly. A reserve currency also requires a deep and liquid bond market, free from government interference.” If China is able to achieve any of these feats, capital will likely pour in at an even faster rate, making an appreciation in the Yuan once again self-fulfilling.

The last week brought a few more developments in China’s quest to turn the Yuan into a viable reserve currency. Don’t get me wrong – I used the term “inches” in the title of this post for a reason – the Yuan will not supplant the Dollar anytime soon, if ever. Still, China deserves credit for their resolve on forcing the issue, as well as for providing an alternative to the Dollar monopoly.

An important boost came from Russia’s Finance Minster, who suggested that, “This could take 10 years but after that the yuan would be in demand and it is the shortest route to the creation of a new world reserve currency,” as long as it was accompanied by economic and exchange rate liberalization. The Head of the World Bank, Robert Zoellick, agreed: “Ultimately, that’s a good thing. And ultimately it’s good if you’ve got, I think, some multipolarity of reserve currencies to create, to make sure that people manage them well.”

These soft endorsements were precipitated by comments from a top Chinese banker that companies should start to issue bonds denominated in Yuan. “Guo Shuqing, the chairman of state-controlled China Construction Bank (CCB), also said he is exploring the possibility of issuing loans to trading companies in yuan, allowing Chinese and foreign companies to settle their bills in yuan rather than in dollars.” This would serve two ends simultaneously; not only would Chinese capital markets be strengthened, but the Chinese Yuan would benefit from the increased exposure. Already, “HSBC and Standard Chartered have both said they are preparing to issue bonds denominated in yuan” and international monetary institutions might not be far behind.

Conspiracies aside, the Chinese Yuan will become a reserve currency when it is ready to become a reserve currency. I’m sure this seems self-evident, but it’s important for China (and China watchers) not to get ahead of itself. It doesn’t make sense for risk-averse investors to hold a currency that is still essentially pegged to the US Dollar and that isn’t fully convertible. If there’s no pretense that the Yuan fluctuates in accordance with market forces, and if investors aren’t guaranteed the ability to withdraw RMB if need be, what possible reason would they have to hold it in the first place?

Summarizes one columnist, “China would have to gradually make the yuan convertible on the capital account; it needed a more liquid foreign exchange market; its bond markets and banking system needed to be more developed; and there had to be proper monitoring of cross-border capital flows.” The importance of having functioning capital markets cannot be understated. Simply, investors and Central Banks buying Yuan would not want to simply invest in paper currency; instead they would want stocks and bonds that trade transparently.

Currently, foreign investors are limited to savings accounts and investing/lending to firms that record earnings opaquely and are ultimately subject to the whims of the Central government. This system has functioned well in the past, only because investors were betting generally on the Yuan’s appreciation, and not necessarily on specific opportunities within China. If China wants the Yuan to be a serious contender with the Dollar, it needs to give investors more and better options. Ironically, if China had taken these steps in the past, it wouldn’t have found itself with $2 Trillion worth of Dollar assets that it is desperately trying to dispose of.

According to a recent Reuters poll, investors are increasingly bullish on emerging market Asian currencies, including the Taiwan dollar, Indonesian rupiah, Singapore dollar, Malaysian ringgit, Philippine peso, South Korean won, and Indian rupee. The Thai Baht wasn’t covered by the poll, but given its strong performance over the last few months, it seems safe to include it in the bunch.

This uptick in sentiment is somewhat unspectacular, since “The Bloomberg-JPMorgan Asia Dollar Index, which tracks the 10 most-active regional currencies,” has now risen for almost three consecutive months [See chart below]. Leading the pack are the Taiwan Dollar and South Korean Won, which recently touched five-month and seven-month highs, respectively. “The Korean currency has climbed 28 percent since reaching an 11-year low of 1,597.45 in March.”

Investors are now pouring money back into Asia at rapid clip. “Asia ex-Japan received $933 million in the week ended May 20, the most among emerging-market stock funds, bringing the total this year to $6.9 billion.” Meanwhile, the “The MSCI Asia Pacific Index of regional stocks climbed 22 percent this quarter” while Chinese stocks are up 45% since the beginning of 2009.

But it’s unclear – doubtful is a better word – whether this rally is supported by economic fundamentals. One commentator summarized this contradiction as follows: “Improved sentiment has led to a massive resurgence in flows to emerging markets, irrespective of the underlying data, which remains weak. Investors are going out of dollars to riskier markets, riskier currencies.”

Let’s drill down into some of the data. Chinese exports fell 15% in April. Japan’s economy contracted 15% in the most recent quarter. Singapore’s exports are down 20% on an annualized basis. The South Korean economy is projected to shrink by 2% this year. The Central Bank of Thailand just cut its benchmark interest rate to an unbelievable 1%. The only bright spot economically is Taiwan, which is benefiting both from improved economic ties with China and a healthy current account surplus. I suppose everything is relative, as “developing Asian economies will grow 4.8 percent in 2009, even as the world economy contracts 1.3 percent” according to the International Monetary Fund.

The notion that the rally is not rooted in fundamentals is shared by the region’s Central Banks, which clearly realize that economic recovery will be much more difficult in the face of currency appreciation. One analyst argues that, “Until the signs of global economic recovery become more convincing, central banks will unlikely tolerate significant currency appreciation.” The Central Banks of South Korea, Taiwan, and Indonesia have already actively intervened to hold their currencies down, while Malaysia and Singapore (discussed in a Forexblog post last week) have also intervened for the sake of stability.

As a result, this rally could soon begin to lose steam. “A ‘correction’ in regional currencies is ‘appropriate’ following recent gains,” said one analyst. Another has called the rally “overdone.” Still, Central Banks and economic data pale in comparison to capital flows and risk/reward analysis. In short, these currencies (and other investments) will continue to find buyers for as long as there are those hungry for risk. Citigroup, whose “Asia-Pacific foreign-exchange volume may rise about 10 percent from the first quarter,” is bullish. A representative of the firm declared: “Fund managers are still ‘sitting on lots and lots of cash’ so the pickup in volumes will continue.”

Based on the title, you’re probably groaning: ‘Wait, I thought this was supposed to be a forex blog?” Bear with me, however, as this subject is extremely pertinent to forex.

Last week, it was revealed that China has been clandestinely adding to its gold reserves since 2003, to the extent that its holdings increased by 76%, to approximately 1,050 tons. The news initially sent a ripple through forex and commodities markets, which were overwhelmed by the figures involved. After analysts had a chance to gather some perspective, however, the markets relaxed. You see, although the increase seems tremendous in size, it is quite small in relative terms.

It is relatively small compared to other countries: “This places China fifth in the world, ahead of Switzerland’s 1040 tons but behind the U.S. ranked first with 8,133 tons, followed by Germany (3,412 tons), France (2,508 tons) and Italy (2,451 tons).”

It is relatively small given the six-year duration of accumulation: “I think as soon as people realized it’s not a year-on-year increase, or a quarter-on-quarter increase, people realized it should not have that big an impact.”

It is small relative to China’s mammoth $2 Trillion forex reserves: “As a proportion of foreign exchange reserves, which have risen five-fold over the same period, gold now stands at a tiny 1.6 percent, versus 1.7 percent in 2003.”

On some level, the development has at least some symbolic importance, as it demonstrates that it cannot be taken for granted that China will simply continue to plow its (dwindling) trade surplus into Dollar-denominated securities, or even currencies in general. This is underscored by the suspicious timing of the announcement; China essentially waited six years before revealing its buildup in gold, probably in order to coincide with the uproar surrounding the Dollar’s role as global reserve currency. In other words, even though China’s gold purchases in and of themselves don’t amount to much, the Central Bank of China is trying to send a message that it will defend itself against “the depreciation risk of some foreign currencies.”

The announcement also explains the recent buoyancy of gold prices. Historically, there existed an inverse correlation between gold and the Dollar. This correlation has all but broken down as a result of the credit crisis, and for the first time a strong Dollar has been accompanied by high gold prices. Part of the reason may be increased buying activity by Central Banks, including the Bank of China: “The physical market remained well-bid by an unknown buyer despite bullion prices spiking to levels that normally cooled demand…Purchases were made in Shanghai, traders said, in an effort to absorb domestic production and lessen the impact of bullion prices on global markets.”

There was tremendous speculation surrounding today’s release of the US Treasury’s semi-annual report to Congress on exchange rates. Considering that Treasury Secretary Geithner accused China unequivocally of currency manipulation during his confirmation hearing in January, it would seem that an official condemnation was inevitable.

Alas, the report once again exonerated China: “In the current Report, Treasury did not find that any major trading partner had manipulated its exchange rate for the purposes of preventing effective balance of payments adjustment or to gain unfair competitive advantage.” The press release accompanying the report made a point of justifying the decision to exclude China: “First, China has taken steps to enhance exchange rate flexibility….Second, the Chinese currency appreciated by 16.6 percent in real effective terms between the end of June 2008 and the end of February 2009….Even so, Treasury remains of the view that the renminbi is undervalued.”

There was certainly a political calculus that went into the decision. There has been a great deal of talk recently regarding China’s growing unease over its US investments, and its consequent willingness to contribute to funding the upcoming US budget deficits. Asks one analyst rhetorically, “If the Obama administration encourages the Chinese government to keep rolling their dollars into US Treasury bonds, then how can the Chinese do this without stabilizing the exchange rates?”

There is also mounting economic evidence that China is no longer manipulating the Yuan, at least not to the same extent as before. China’s foreign exchange reserves, which it must accumulate as part of its efforts to depress its currency, are growing at the slowest pace in nearly a decade. In the first quarter of 2009, its reserves grew by only $7 Billion, compared to an increase of $150 Billion in the first quarter of 2008. This can be explained as follows: “China’s first-quarter trade surplus shrank 45 percent from the previous three months and foreign direct investment tumbled as the global recession choked off demand.” According to another economist, “Inflow through buying properties and speculation was a big part of foreign exchange increase in the past few years, and we are seeing a bit of unwinding as new money is not coming in.”

On the other hand, there are signs that China’s economic stimulus plan has begun to trickle down to the bedrock of the economy. The Chinese money supply expanded by a record 25.5% in March, as a result of a six-fold increase in lending. Today’s release of GDP figures revealed that “By March the economy was gaining more speed, with the year-on-year increase in industrial production rising to 8.3% from an average of 3.8% in the previous two months. Retail sales were 16% higher in real terms than a year ago, and fixed investment has soared by 30%.” In short, it looks like the increase in investment and government spending will at least partially offset the projected 10% decrease in 2009 exports. [Chart below via The Economist].

Having appealed unsuccessfully to the G20 to create a viable reserve currency, China is now taking matters into its own hands, by pushing the Chinese Yuan as a viable alternative.

Earlier this week, it signed a $10 Billion+ swap agreement with Argentina, involving an exchange of Argentine pesos for RMB. The agreement is ostensibly designed to benefit Argentina, whose economy has been hit hard from the global credit crisis: “The peso has been weakening slowly but consistently since mid-2008, when a major farm strike here spooked investors and led many Argentines to trade in their pesos for dollars.” By guaranteeing a large quantity of RMB – which is generally considered undervalued- China is effectively providing the peso with more solid backing.

In actuality, the swap was probably proposed by China in order to demonstrate its sincerity in seeing the Dollar replaced as reserve currency. Especially among developing countries and/or Asian countries, many of which represent major trading partners, China is keen to increase the supply of Yuan. One analyst wrote that ” ‘We expect more agreements with other emerging market countries will be in the pipeline,’ as the swaps will help ‘Chinese slumping exports by making access to finance easier.’ ” Accordingly, the swap agreement with Argentina represented the sixth bilateral currency agreement signed by China in recent months. The other five countries are Belarus, South Korea, Hong Kong, Malaysia, and Indonesia, with the total nominal swap value of nearly $100Billion ($650 Billion RMB).

China is also moving to make the Yuan fully convertible, such that it can be exchanged freely both inside and outside China. It is intended that Chinese banks and exporters, for example, will now be able to accept payment directly in foreign currencies, rather than first being forced to convert them into RMB. In addition, the government “will triple the amount of domestic securities that overseas funds can buy under the qualified foreign institutional investors program to $30 billion” in order to make it easier for foreigners to invest directly in China.

While the moves announced so far are too small to make any meaningful waves in the forex world, investors seem generally supportive of China’s efforts. Remember that only two years ago, hedge fund manager Jim Rogers famously announced that the RMB was due to appreciate 500% over the next couple decades and subsequently moved much of his personal savings into RMB-denominated bank accounts.

A recent note by Citigroup analysts perfectly encapsulates this sentiment: “In the longer term, we think it is China’s strategic economic and political interest to promote the broader use or internationalization of CNY. While the internationalization of CNY has a very long way to go, we see China as using the global crisis as an opportunity to take early steps.” Of course, China itself is conscious that such a process will require decades to complete, but it remains cautiously optimistic: “It’s not really up to China to determine this. It’s up to the market…The best the government can do is to permit yuan-denominated trade. And then it’s up to the market to decide whether it wants to use that.”

Since Chinese Premier Wen Jiabao (as the ForexBlog reported here) expressed doubts about China’s US loans and investments two weeks ago, the markets have been awash in speculation. In hindsight, it seems that the announcement was a political ploy, rather than a harbinger for a policy change. With a few qualifications, therefore, it seems to safe to conclude that China’s foreign exchange reserves will not undergo any serious changes in the near-term.

Motivated both by politics and pragmatism, “China’s top foreign-exchange official said the nation will keep buying Treasuries and endorsed the dollar’s global role. Treasuries form ‘an important element of China’s investment strategy for its foreign-currency reserves,’ she said at a briefing in Beijing today. ‘We will continue this practice.’ ” The economic fortunes of China and the US have become increasingly intertwined over the last decade, such that China has come to depend on exports to the US to drive economic growth, while the US simultaneously depends on China to fund its fiscal and current account deficits. As a result, “about two-thirds of China’s nearly $2 trillion in reserves is parked in dollar assets, primarily U.S. government and other bonds.”

Even ignoring the potential political fallout from forex reserve diversification, such a move doesn’t really make practical sense. First of all, there isn’t a buyer sufficiently capitalized to relieve China of its US Treasury burden. “If China decided to sell off some of its U.S. Treasury holdings, it would scarcely be able to dump that in large blocks. And a partial selloff would surely lead to a slump in the Treasury market, eroding the remaining value of China’s portfolio.”

In addition, there doesn’t currently exist a viable alternative to US Treasury securities, nor to investing in the US, for that matter. China’s attempt at diversifying into corporate bonds and equities was extremely ill-timed, having been implemented just prior to the puncture of the real estate and stock market bubbles. Including the collapse in the value of its high-profile investments in the Blackstone Group and Morgan Stanley, total paper losses are estimated at a whopping $80 Billion. Investments in other currencies and markets, meanwhile, probably would have yielded similarly poor returns. The market for gold- mulled by some as a theoretical alternative- is even more volatile and “not large enough to absorb more than a small proportion of China’s reserves.”

As a result, China’s forex reserve diversification strategy is likely to proceed along two lines: change in duration of loans, and investments in natural resources. “The risk of short-term national debt is comparatively more controllable. China increased its holding of short-term US bonds by $40.4 billion, $56 billion, and $38 billion in September, October and November, respectively. At that time, China began to sell long-term government debt.” Through its affiliates meanwhile, China’s Central Bank is cautiously making stealthy forays into natural resources; see its recently-acquired a $20 Billion stake in Rio Tinto, an aluminum company, as evidence of this strategy.

Of course, China has announced tentative support for loaning money to the IMF and backing an ‘international’ reserve currency that would serve as an alternative to the Dollar. Given that this is probably many years away, however, it has little choice but to continue to hold Treasuries and the like. In the words of a high-ranking Chinese official: “We are in the middle of a crisis right now, and the priority for foreign exchange reserves is to minimize losses.”

China seems to have fulfilled its promise of a stable currency, given that the Yuan/Dollar exchange rate is one of the few bastions of stability in forex markets. One Dollar trades for approximately 6.83 CNY, about the same as it did last summer. Futures prices, meanwhile, reflect a mean expectation that one year from now, the exchange rate will dip only slightly, to 6.86 CNY/USD. [The inverse is depicted in the chart below].

In fact, there is even evidence that China is fighting market forces by trying to prop up the value of the Yuan. “‘ If this were a market-determined exchange rate, it would now be weakening, because the overall balance of payments looks to be in deficit, but it is not weakening,’ said [one economist]. ‘The implication is that authorities must be selling their dollar reserves in order to stabilise the USD-CNY exchange rate.’ ” Of course, it’s difficult to determine for sure, since the decline in China’s forex reserves that constitutes the basis for this claim could also have been caused by paper-losses on depreciating investments.

Within China, there is a core group of academics that continues to insist that China should depreciate its currency in response to deteriorating economic conditions. After all, China’s trade “surplus narrowed in February to $4.8 billion from about $40 billion in each of the previous three months, and in all likelihood will fall for the first time in five years in 2009.” Meanwhile, economists estimate that GDP growth could slow to 6%, a far cry from the 13% chalked up in 2007, and well below the government’s goal of 8%.

Some Chinese analysts also take issue with the notion of a ‘stable’ currency. ” ‘The stability we expect is not only stability against the USD, but against all currencies,’ said MoC researcher Li Jian. ‘What is stability? Now the RMB is stable against the USD, but is appreciating against the euro, Australian dollar and the yen, so RMB’s exchange rates against these currencies are not stable.’ ” This is an important distinction, since China’s trade rivals are mostly nearby Asian countries- not the US. “Since July, the yuan is up 33% against the Korean won and up 12% against the Singapore dollar, for example. This has made Chinese exports relatively less competitive while spurring more imports and thereby providing somewhat of a boost to other economies.”

In the US, meanwhile, there are still policymakers that insist that the Yuan is undervalued, and the Treasury Department may brand China as a “currency manipulator” in its next semi-annual report. In the end, “with China holding its currency stable against the dollar even as its trade position has weakened, Washington’s long-standing argument that Beijing is keeping the yuan unjustifiably low is losing weight.”

US Treasury yields have been held low across the short-term and long-term due in part to a lack of appealing investment opportunities in a deflationary period, while the Federal Reserve announced in January the possibility of buying long-term US government Treasury bonds to help hold down long-term interest rates (and thus mortgage rates), hoping for a slow controlled decent in housing prices.

At the other end of the spectrum, the US government has been bailing out every large financial institution willing to accept a few billion here or there, and running the printing presses in overdrive.

Excess supply of a commodity or product usually is reflected in downside pressure on its price, and the same is true for money. Excessive supply of money leads to its debasement, to a decline in its value that otherwise is known as inflation. Where money supply generally is an underpinning of economic activity, it also is the ultimate determinant of prices and inflation. At present, near-record high annual growth in the broadest U.S. money measure M3 is suggesting a significant inflation problem in the year ahead.

The Chinese have nearly 2 trillion Dollars in their reserves, with roughly 2/3 of them being denominated in US Dollars. Seeing their own economy slow, and the coming risk of inflation, the Chinese government is looking to shift some of their reserves away from US Dollars to hard commodities, particularly oil. Marketwatch reports:

China is considering plans to tap its foreign reserves to buy crude oil as part of a push to diversify holdings from U.S. Treasurys, according to a published report.

With the U.S. issuing massive amounts of government bonds to finance economic stimulus measures, Chinese officials are looking to hedge against the risk of Treasury prices dropping.

China, which has been building up a national oil stockpile since 2004, aims to amass 100 million barrels by next year as a first step, the Japanese business daily Nikkei reported.

After nearly six months of currency depreciation, the nations of Asia have finally been spurred to action. Japan, China, and South Korea have joined together with the 10 ASEAN economies to form a $120 Billion pool of foreign exchange reserves, which contributors can tap into to protect their currencies. The goal is to prevent capital flight and currency weakness from engendering the same kind of financial crisis that only 10 years ago ravaged Asia. Fortunately, this time around, the 13 countries possess a combined $3.6 Trillion in reserves, which can be deployed in forex and securities markets in order to restore investor confidence. Ironically, the bulk of these reserves belong to China and Japan (who are also funding a large portion of the forex pool), both of whose currencies remain strong in spite of the crisis. Bloomberg News reports:

The fund is aimed at ensuring central banks have enough to shield their currencies from speculative attacks such as those that depleted the reserves of Indonesia, Thailand and South Korea during the 1997-1998 financial crisis.

While China remains committed, in rhetoric at least, to a flexible Chinese Yuan that rises and falls in accordance with market forces, its actions suggest otherwise. Beginning in the second half of 2008, China stopped allowing the Yuan to appreciate, for fear that a more expensive currency would exacerbate the domestic effects of the credit crisis by making exports less competitive. What China fails to realize however, is that a more valuable Yuan is not only conducive to global economic stability, but also to its own economic well-being. In fact, the artificially cheap Yuan may have actually worsened the economic downturn in China, because de-incentivized the creation of a domestic economic base. Now that overseas demand has dried up, it is left feeling the consequences of this neglect. The San Francisco Chronicle reports:

With China far too dependent on export-driven growth, it is now extremely vulnerable to the current steep decline in global export demand. Unless that structural imbalance is fixed, China’s long-term growth prospects are as bleak as those of the United States.

Speculation surrounding the Chinese Yuan has been mounting for months, beginning with a sudden halt to the currency's appreciation and continuing with the insinuation of the Obama administration that China is a currency manipulator. In the context of falling exports and a sagging economy, meanwhile, the Chinese Ministry of Finance has issued a research report encouraging the Central Bank to allow the currency to appreciate. Despite the Central Bank's insistence that it wants a "stable" currency, futures prices indicate a mean expectation that in fact, the Yuan will be nudged downward over the next twelve months. On the other side of the equation are financial analysts, who collectively forecast a slightly stronger Yuan, with one bullish analyst projecting a 3.5% appreciation in 2009, on the basis of selectively culled economic data. Bloomberg News reports:

“The consensus around China has been weak growth and falling reserves. The recent data challenges both views. Lending looks good, money supply looks good, and the PMI balanced to slightly bad from very bad levels.”

It appears Timothy Geithner, recently-appointed US Treasury Secretary, was not exaggerating when he declared that the Obama administration intends to address China's currency policy. No less than President Obama himself rrecently called Hu JinTao, President of China, to inform him likewise. Unfortunately, the administration does not exactly have support from political and economic analysts. They argue that not only is the Yuan's "true" value debatable, but also that now is not an opportune time to pursue this issue, due to current economic circumstances. Givent that the Yuan has been permitted to appreciate almost 20% in the last four years and that the Chinese accumulation of forex reserves has begun to slow, perhaps Obama's prodding could even backfire. Bloomberg News reports:

During his confirmation hearings, Treasury Secretary Geithner indicated that the Obama administration consensus is that China is manipulating the Yuan. China predictably refuted the charges, and indicated that it will not be bullied into submission by the US when managing its currency. Thus began a heated back-and-forth between US and Chinese economic officials, with the forex markets caught awkwardly in the middle. Geithner apparently doesn't realize that his position also carries important diplomatic responsibilities, namely helping the US government to pay its bills by ensuring a steady demand for US Treasury securities abroad. Offending the most reliable foreign lender, accordingly, is probably not the best strategy to fulfilling this role. Moreover, Geithner's testimony couldn't have occurred at a worse time, given the planned expansion of US debt and the simultaneous leveling off of China's forex reserves. The implications for the Dollar couldn't be clearer. Forbes reports:

China has been a major purchaser of America's official debt in recent years. If it were to stop…Geithner would likely find his Treasury paper having to offer higher yields to draw investors, putting new pressure on the American budget.

While much has been written about the forex implications of the Barack Obama Presidency, most of the commentary has focused on the Dollar, at the expense of reporting on other currencies. The Chinese Yuan, to name one such currency, could soon find its fate tied closely to Obama; it has been widely speculated that he will compensate for the reticence of his predecessor by formally labeling China a currency manipulator and pressuring its to allow the RMB to appreciate at a faster pace. Timothy Geithner, who is set to be confirmed as the next Treasury Secretary, has echoed similar sentiments. It is unclear whether such a sentiment would achieve the necessary legislative support required to levy punitive sanctions against China in order to force it into submission. Given the current global economic climate, however, it seems unlikely that China would comply. Marketwatch reports:

In fact, China itself has every reason to avoid both depreciation and appreciation of its currency. The latter could further weigh on already drooping exports, and the former could lead to capital outflows from the country, at a time it can least afford this.

Anyone curious about whether China is intentionally allowing the RMB to depreciate, need look no further than the Central Bank's latest forex reserve figures, which registered a decline for the first time in nearly six years. At the same time, Chinese trade figures indicate that exports fell for the first time in seven years, which limits the government's ability to build up new reserves. As a result of the credit crisis, it's conceivable that the Central Bank will continue to spend down its reserves in order to provide a boost to its faltering economy. US President-elect Obama will have to deal with such forces if he wishes to successfully take on China's currency policy. Otherwise, the RMB currency could appreciate in 2009, bucking its trend over the last few years.

Only a few weeks ago, investors had made significant bets that China would reverse its official policy of RMB appreciation. Futures prices indicated that investors collectively expected the currency to depreciate over 7% against the Dollar over the next year, as part of a comprehensive Chinese policy to boost the faltering economy. Since then, however, the RMB recorded its biggest one-day rise since the currency peg was abandoned three years ago, and investors subsequently scaled back their bets.

While it's unclear what caused the sudden change in sentiment, there are a few factors which probably contributed. First is Treasury Secretary Henry Paulson's recent visit to China, in which he encouraged China to continue to permit the the Yuan to appreciate. In addition, high-ranking Chinese economic policy-makers have indicated that market forces will increasingly determine the valuation of the Yuan. Finally, there is the recent election of Barack Obama, a long-standing critic of what he believes to be the undervalued RMB. Bloomberg News reports:

"Any attempt to devalue the currency is likely to be met with considerable opposition from China’s trading partners." The new U.S. administration under President-elect Barack Obama "will be less tolerant of the 'crawling peg' appreciation policy," said one analyst.

When all is said and done, the US government will have injected trillions of dollars into the economy, in the form of bailouts, guarantees, economic stimuli, etc. Whether it will have the desired effect is debatable. The question that no one seems to be asking is, "How is the government going to finance such exorbitant spending?" It appears that China, which has become of of the largest holders of US government debt, will continue to participate- not necessarily because it wants to, but because it doesn't have a choice. China's economy remains heavily reliant on the export sector to drive growth. Because its exchange rate regime does notpermit the RMB to fluctuate freely, the proceeds from the consequent trade surplus must be invested abroad, rather than domestically. For both symbolic and economic reasons, it seems the bulk of the surplus will continue to be invested in the US, probably in safer assets like US Treasury Securities. This is certainly good news for deficit hawks and Dollar bulls. The Wall Street Journal reports:

Even if China wanted to invest outside the U.S., it couldn't. If China recycled its foreign currency into, for instance, the European Union or Japan, it would effectively force those trading partners to run large trade deficits with China, which neither can absorb.

Since China revalued the Yuan in July 2005, it was considered a foregone conclusion that the currency would continue appreciating at a steady clip. The global credit crisis, generally, and the Chinese economic downturn, specifically, has turned that assumption on its head. Last week, the RMB declined by the biggest margin since the revaluation, prompting speculation that China will adopt a currency policy diametrically opposed to that which it has pursued over the last few years. The move also coincided with the annual China-US trade summit, attended by none other than Treasury Secretary Henry Paulson. The new consensus among currency traders (proxied by futures contracts) is that the Yuan will depreciate slightly over the next two years, as China moves to provide a boost to its export sector. Given that the currencies of most of China’s Asian neighbors have fallen by double digits over the last year, the Yuan may have to fall sharply in order to maintain competitiveness. The Wall Street Journal reports:

the Chinese currency hasn’t experienced a large devaluation in at least a decade. Such a move would go against the realities of geopolitics and against signals that Beijing is more focused on boosting domestic consumption than on stimulating exports.

After rising nearly 20% over the last three years, the RMB has virtually stopped appreciating against the US Dollar, perhaps as a result of the credit crisis. At the same time, the US exports sector- previously one of the few bright spots of the sagging economy- has begun to stall. US Politicians have taken note, and are now renewing their efforts to persuade China to allow its currency to rise further. They are also agitated about China’s perpetually growing forex reserves (currently estimated at $2 Trillion), which are increasingly being deployed in sensitive areas. Meanwhile, the Chinese economy is growing at the slowest pace in years, and the Chinese government is resorting to desperate measures to prop it up. In short, allowing the RMB to rise, while placating US policymakers, is tantamount to economic suicide, and hence unlikely.

While other sovereign wealth funds have existed for nearly 50 years without controversy, "China appears far less likely than other nations to manage its sovereign wealth funds without regard to political influence that it can gain by offering such sizable investments."

Last week, China revealed that in the most recent quarter, its economy grew at the slowest pace in nearly five years. It also revealed that its foreign exchange reserves crossed $1.9 Trillion, due to a record monthly trade surplus. How can this seeming contradiction in economic peformance be reconciled? In my opinion, the Chinese economy will continue to slow as a result of a generalized post-olympics slowdown and falling export demand brought on by the global economic crisis. The consequent collapse in risk appetite will bear negatively on investing in Chinese assets. Its stock market has already lost 50% of its value this year, and foreign direct investment (which is more difficult to monitor) is certainly sliding. In other words, there will be less foreign capital for the Central Bank to soak up, and less pressure on the RMB to appreciate. AFP reports:

The various factors at play could actually be causing some capital outflows as troubled foreign firms and investors may need the money overseas.

Over the last couple years, the Central Bank of China has built up a treasure trove of foreign exchange reserves ($1.8 Trillion at last count), as part of its effort to hold down the Yuan, or at least slow its appreciation. Unfortunately, these reserves have depreciated significantly-10% per year in real terms- as the Yuan has risen relative to the Dollar. These reserves may slide further in real terms, as the credit crisis diminishes the value of the mortgage securities that comprise almost 20% of its portfolio. In order toshore up its capital position, the Bank may be forced to accept an infusion of capital from China’s Finance Ministry and halt the appreciation of the Chinese Yuan. The New York Times reports:

China finds itself hemmed in. If it were to curtail its purchases of dollar-denominated securities drastically, the dollar would likely fall and American interest rates could soar.

Everyone has a theory to explain the Dollar’s explosive rally, which has yet to run out of steam. A recent one identifies a shift in China’s forex reserve policy as a driving force. Apparently, in an ostensible effort to clamp down on inflation, the Central Bank of China is resorting to draconian measures. One rule change, which was executed with both speed and lack of media coverage, requires commercial banks to hold a larger portion of their reserves in Dollars, rather than Chinese Yuan. In addition, such banks face new restrictions on foreign debt, which is designed to turn them into net buyers of Dollars. Analysts suggest that this policy represents a roundabout attempt to slow the appreciation of the Chinese Yuan. If they are correct, than surely the Central Bank of China has succeeded, for the currency has virtually ceased in its interminable upward march against the Dollar. This upshot suggests that the goal of the Central Bank was not to fight inflation, but rather to avoid a post-Olympic economic slowdown. The Telegraph reports:

They are now more worried about growth than overheating, and you are seeing that play out in the currency markets. There has been a remarkable change of view."

Almost all of the speculation surrounding the Chinese Yuan is aimed at predicting the point at which the currency will stop rising. Will it stop at 6.5? 6? 5? 1? But what if the currency has already peaked, at least temporarily? The Central Bank of China is now openly airing its concerns about a slowing economy, which it believes is more problematic than the country’s surging inflation rate. Accordingly, it will probably relax interest rates and slow the appreciation of the currency, in order to give businesses and exporters the leverage they need to keep the economy going. In fact, the Central Bank already announced a $50 Billion plan to prop up ailing capital and property markets. Such measures are likely to further stoke the fires of inflation, at a time when prices are already rising at the fastest pace in a decade. The futures markets have been quick to take note, and expectations for Yuan appreciation are falling accordingly. Bloomberg News reports:

[Futures contracts] suggest the yuan will reach 6.6060 per dollar in the next 12 months, an advance of 3.8 percent from the current exchange rate. Two weeks ago the contracts, predicted an advance of 5.3 percent. At the start of last month, they priced in a 6 percent rise.

Almost all of the speculation surrounding the Chinese Yuan is aimed at predicting the point at which the currency will stop rising. Will it stop at 6.5? 6? 5? 1? But what if the currency has already peaked, at least temporarily? The Central Bank of China is now openly airing its concerns about a slowing economy, which it believes is more problematic than the country’s surging inflation rate. Accordingly, it will probably relax interest rates and slow the appreciation of the currency, in order to give businesses and exporters the leverage they need to keep the economy going. In fact, the Central Bank already announced a $50 Billion plan to prop up ailing capital and property markets. Such measures are likely to further stoke the fires of inflation, at a time when prices are already rising at the fastest pace in a decade. The futures markets have been quick to take note, and expectations for Yuan appreciation are falling accordingly. Bloomberg News reports:

[Futures contracts] suggest the yuan will reach 6.6060 per dollar in the next 12 months, an advance of 3.8 percent from the current exchange rate. Two weeks ago the contracts, predicted an advance of 5.3 percent. At the start of last month, they priced in a 6 percent rise.

As the Chinese Yuan has appreciated over the last three years, and even in the decade leading up to the sudden revaluation, a tremendous amount of speculative "hot money" poured into China. Periodically, the government and Central bank have attempted to stem some of these inflows by creating deliberately unfavorable conditions for foreigners to invest in China. Witness the unnaturally low interest rates and the one-way convertibility of the Chinese Yuan. Now, with inflation running at a 10-year high, the government is becoming more serious in its efforts to clamp down on some of the factors that are driving demand. As a result, it altered its system for governing forex and will increase its oversight over the entities and businesses that import capital into China. If executed properly, much of the upward pressure on prices, and the RMB itself, could be relieved. Reuters reports:

NEW RULES: China operates "a managed float exchange rate system based on supply and demand".

OLD RULES: China has "a single exchange rate system" with the central bank announcing the yuan’s value against major currencies on a daily basis.

Yesterday, the Forex Blog reported that Central Banks and Sovereign Wealth Funds appear to be losing confidence in the Dollar. To follow up with a specific example, a high-ranking Chinese policymaker recently suggested that China should move spend some of its reserves since they are rapidly losing value in RMB terms. The official offered that a portion be used to purchase foreign energy assets, in order to mitigate against both the falling Dollar and rising oil. There is clearly a trend among institutional holders of Dollars to use the currency to purchase US assets. Witness the recent (separate) sales of the Chrysler and GM Buildings to Middle Eastern buyers. With nearly $2 Trillion in foreign exchange reserves, however, China is in a class by itself, and any indication of its frustration with the Dollar should be taken very seriously.

In the year-to-date, the Chinese Yuan has already appreciated 6.5% against the USD, the fastest pace since the currency was famously revalued three years ago. This upward pressure has been built largely on the continuing inflow of speculative "hot money," which was itself built on the expectation of further interest rate hikes, ostensibly needed to tame inflation. However, the Central Bank of China recently indicated a slight shift in its monetary policy, backing away from fighting inflation in favor of promoting economic growth. At least until after the Olympic Games conclude, China will henceforth ignore inflation, so as not to precipitate a slowdown that could jeopardize the Games. The Futures markets have been quick to react, and the consensus expectation for 1-year RMB appreciation has fallen from 10% to 5.4%. Bloomberg News reports:

Once the Olympics are out of the way, the vigil on inflation may have to resume. But unless China gets flooded by speculative flows, a one-shot revaluation will remain off the table.

The first half of 2008 has come to a dramatic end, and it’s official: China’s stock market was the world’s worst performer, finishing down 48%. Ironically, some analysts believe this may be a harbinger for a faster appreciation of the Chinese Yuan. While the global credit crisis cannot be completely disentangled from the Chinese macroeconomic picture, certain conclusions can be drawn that are specific to China. In a nutshell, the party may be over. Inflation has surged to a 10-year high, economic growth is slowing, and stocks are facing a prolonged bear market. The Chinese government will likely continue to bide its time so as not to disrupt the Olympics. After the conclusion of the games, however, the Central Bank may begin aggressively hiking rates in order to tame inflation. While this would adversely affect economic growth, it would cause the RMB to appreciate. Forbes reports:

Maybe that’s what Shanghai’s decline is really telling us, that the China miracle may be losing some of its luster, as China tries to make the transition from a low-cost exporter to a leading provider of 21st century goods and services.

When China’s foreign exchange reserves breached the $1 Trillion mark in November 2006, it was a momentous occasion. Over the following 18 months, however, analysts yawned as the reserves nearly doubled in size. In the month of April, alone, China added an astounding $75 Billion to its stockpile, bringing the total to $1.76 Billion. Analysts attribute this sudden increase to a massive inflow of hot money, as investors seek to profit from both the Yuan’s inevitable appreciation and the widening interest rate spread between China and the US. The Central Bank of China also recently announced the official 2007 trade numbers, which reveal a 49% increase in the country’s current account surplus, to $370 Billion. By no coincidence, this news caused the highest daily appreciation in the Chinese Yuan in more than three months. Bloomberg News reports:

China has allowed a 2.6 percent gain over the past three months, making it Asia’s best performer among the 10 most-active currencies in the region outside Japan.

In its semiannual report to Congress, the US Treasury Department once again did not cite China as a currency manipulator. For as long as the Forex Blog has been covering this issue, various interest groups have been pressing the Bush administration on this issue, since the label of currency manipulator would entitle Congress to level punitive trade sanctions. The premise of their argument remains that an artificially cheap RMB is responsible for the decline of the US manufacturing sector and the burgeoning trade deficit, which topped $250 Billion in 2007.

The Treasury Department, under the leadership of Henry Paulson, insists that the best way to handle the situation is through dialog. In its report, it noted that the RMB has already appreciated over 18% since China’s government revalued it in 2004. However, with the Presidential election looming, the RMB could become a major political issue. Already, both Hilary Clinton and Barack Obama have announced their intention to co-sponsor a bill that would impose trade sanctions on countries (i.e. China) that are deemed to undervalue their currency. In the end, politicians will continue to whine in vain to appease their constituents, and the RMB will continue climbing at its brisk, current pace of 7% per year.

The anecdotal evidence that China is diversifying its forex exposure away from the Dollar continues to mount. To date, most of the focus has centered around the Central Bank of China, which is passively diversifying its reserves into European and higher-risk assets. Apparently, Chinese exporters are also getting nervous about the impact of a falling Dollar on their respective bottom lines. The RMB has risen 11% since the beginning of 2007, which means Chinese companies now receive 11% less on sales to destinations abroad than they did for equal-priced goods in 2007. As a result, some companies have taken to quoting prices in Euros or to adjusting Dollar-denominated prices every few months. Other companies are building assumptions of a more valuable RMB into their profit models, and setting prices accordingly. The New York Times reports:

“We are gradually increasing our emphasis on the domestic market until we can forget about the export market, because the profit margins on exports are so thin,” [said one exporter].

The lack of fanfare not withstanding, the Chinese Yuan, or RMB, continues to appreciate against the USD. This week, it crossed the psychologically important barrier of 7 RMB/Dollar, a level last seen in the 1990’s. Since its revaluation nearly three years ago, the Yuan has risen 16% against the Dollar, a rate which appears to be growing exponentially given the 4.5% rise already notched in 2008. Due to the Dollar’s continued weakness against all of the major currencies, the RMB has actually fallen against the Euro over the same period. Most analysts reckon the Yuan will continue appreciating, perhaps to 6.5 by year-end. The New York Times reports:

"The appreciating renminbi is a signal the Chinese government is sending to the export companies to switch away from the U.S. and other overseas markets and turn toward the domestic market."

Although the Chinese Yuan is ostensibly allowed to fluctuate in value, the reality is that the size of its fluctuations and the pace of its appreciation are tightly controlled by China’s Central Bank. Since its currency is still effectively fixed to the Dollar, China is severely curtailed in its ability to conduct monetary policy and must closely mirror US policy. Same goes for the rest of Asia, excluding Japan. While US monetary policy was relatively tight, as it has been for the last five years, this necessity didn’t cause too many problems; most of these economies would have kept interest rates high irrespective of the US.

Since the Fed began loosening monetary policy over the last six months, however, many of the emerging economies in Asia, especially China, have been forced into a bind. On the one hand, lowering interest rates is exacerbating the problem of inflation. On the other hand, they want to keep their currencies stable so as not to limit economic growth. In short, Central Banks must determine which is more important: fighting inflation or promoting growth. According to some economists, these economies are so strong, having grown by nearly 10% collectively last year, that they can afford to slow down, if it will result in greater price stability. But the only way to stabilize prices is to drastically raise interest rates, which will put even greater pressure on their currencies to appreciate.

In addition, the Central Banks of Asia have amassed a staggering $4 Trillion in foreign exchange reserves. In the past, this has been a neutral, sometimes profitable activity. Since the Fed began cutting rates, the interest rate differential has been turned upside-down such that Central Banks are now losing money on each unit of local currency they sell in exchange for Dollars. According to one analyst, over $160 Billion has been lost since July 2006, and those losses will mount with each additional intervention.

China’s trade surplus grew 22.6% year-over-year for the month of January, on top of export growth of 26.7%. If there is any silver lining to what many policymakers would consider bad news, it is that growth in imports is slightly outpacing growth in exports. Unfortunately, that is unlikely to allay the critics, and there are still many of them. The argument remains unchanged- that China is not allowing its currency to rise fast enough. On paper, however, the Yuan has appreciated by 15% since China officially de-pegged it from the Dollar in July 2005. In addition, the G7 failed to scold China in its annual meeting, which suggests that economic policymakers are becoming less concerned with China’s forex policy. Ironically, the revaluation of the Yuan is probably boosting the value of of China’s exports in the short-term, because other countries are now paying more for the same quantity of imports. AFP reports:

The International Monetary Fund…urged the Chinese government to loosen the reins on the yuan. "We encourage a faster pace of appreciation that would be helpful for addressing China’s key economic challenges and would also contribute to preserving global economic stability."

China’s foreign exchange reserves currently approximate $1.5 Trillion, the majority of which is denominated in USD. Moreover, the Central Bank of China earns interest on every Dollar it adds to its reserves but must also pay interest on every RMB note that it must issue to offset the Dollars. Since the Fed began easing monetary policy, the amount of carry (the difference between what the Central Bank receives on Dollars and pays on RMB) earned by the Central Bank has completely inverted, such that it now loses 250 basis points on average for each Dollar exchanged for RMB.

Based on the rate at which China is currently accumulating reserves, this amounts to between $5 Billion and $10 Billion per month, depending on which method of accounting is utilized. Furthermore, this trend has been exacerbated because China is accumulating reserves at a faster rate than its economy is growing. Some analysts have speculated that this could turn into a major political issue, with important implications for the RMB/Dollar exchange rate. The Financial Times reports:

The renminbi has started to appreciate more rapidly in recent months, rising at an annualised rate of about 20 per cent, compared with 6-7 per cent over the whole of 2007. In the longer-term, say economists, China will have no choice but to allow its currency to appreciate faster, even in the face of entrenched domestic resistance.

When Henry Paulson was appointed Secretary of the US Treasury last year, he made China and its purportedly undervalued currency a cornerstone of his economic plan. Lo and behold, several months ago, the Yuan suddenly accelerated in its upward path against the Dollar, rising at an annualized rate of 14%. Currency futures are now pricing in an 8% rise in 2008, while several economists are forecasting a 10% increase. Ironically, there are still American policymakers who think the Yuan is appreciating too slowly, as well as Chinese policymakers who reckon it is increasing too rapidly. Accordingly, the current pace probably represents a fair compromise. Besides, inflation is threatening the US, so a slow appreciation would enable the economy to adjust to higher prices in the long term. While China also faces rising inflation, it doesn’t want to send investors the message that the movement of its currency is uni-dimensional, which would encourage further inflows of speculative capital. The Economist reports:

But Chinese policymakers have stressed the need for gradual adjustment.
To show that the currency is not just a one-way bet, the PBOC may try to nudge the yuan a bit lower in coming days.

On January 24 last year, the Forex Blog reported with great fanfare that China’s forex reserves had breached the epic milestone of $1 Trillion. [In hindsight, it turns out that the psychologically important barrier was broken several months earlier, but that is beside the point]. Less than one year later, China’s forex reserves reached another important threshold, soaring past $1.5 Trillion. It appears that new reserves are being accumulated at an exponential rate, having increased $460 Billion last year and over $30 Billion in the month of December alone. By no coincidence, China’s 2007 trade surplus of $262 Billion shattered the previous record and is expanding at a comparably supersonic pace.

Most analysts reckon that the country is locked in a vicious cycle: when its trade surplus grows, its forex reserves grow proportionately. Moreover, the lopsided trade imbalance th\at China maintains with most of the world ensures that the demand for Chinese Yuan exceeds the supply. In the short run, a more expensive currency equates to higher prices paid for its exports which only increases the trade surplus and forex reserves further, and exerts still more pressure on the currency to appreciate. Meanwhile, as the Yuan rises, the value of China’s forex reserves, which are denominated predominantly in USD, falls. What a conundrum indeed! Xinhua News reports:

The value of Chinese RMB against the US dollars has appreciated by over six percent in 2007. The central parity rate of the RMB was 7.2672 to the US dollar on Friday.

Earlier this week, the Chinese Yuan recorded its highest one-day increase in value in the two years since it was famously revalued against the Dollar. The currency rose nearly .4% and prompted renewed speculation that China’s Central Bank will either widen the trading band to .8% or will generally allow the currency to appreciate faster. In fact, the political and economic consensus continues to maintain that the Yuan is not appreciating rapidly enough. While it rose over 6% against the Dollar, for example, it actually lost value to several of the world’s major currencies. Furthermore, its decline against the Dollar is less impressive when China’s skyrocketing inflation rate and burgeoning trade surplus are taken into account.

There are still a few analysts who are bucking the trend and arguing that the Yuan is fairly valued. This notion is supported by a recent World Bank analysis, which updated its calculation of China’s purchasing power and reduced its PPP-equivalent GDP in the process. However, this opinion is echoed by only a small group of analysts, and an overwhelming majority continues to call for and anticipate a further appreciation of the Yuan. Bloomberg News reports:

Forward contracts show traders are betting on an 8.7 percent advance in the yuan to 6.7344 per dollar in the next 12 months. The median estimate of 28 analysts surveyed by Bloomberg News is for a rate of 6.88 by the end of 2008.

Since even before the dawn of the Forex Blog, commentators have been speculating that the US Treasury Department would officially brand China as a "currency manipulator" in its semi-annual report to Congress. Such a label is important because it would enable the US to levy tariffs and other economic penalties against China. However, another report has been issued, and one more time the Treasury Department glossed over China’s de facto control over the Yuan. The report did criticize China for failing to appreciate the RMB rapidly enough, since the 12% gains it has racked up over the last two years have been largely offset by inflation. The report also referred to China’s widening trade surplus and accompanying growth in foreign exchange reserves. US politicians, however, are less than pleased, and are preparing to take matters into their own hands. The Associated Press reports:

"In refusing to brand China as a currency manipulator, which is so obvious, the Administration gives Congress no choice but to act on its own. This report is the strongest case possible for our legislation," said [one high-ranking Senator] Schumer.

The Organization for Economic Cooperation and Development (OECD) recently issued a report on the Chinese Yuan, which thoroughly assessed the currency’s appreciation since it was “revalued” over two years ago. While the Yuan has technically risen over 10% against the USD, the OECD concluded that in real terms, the currency has actually fallen. The official rate of inflation hit 6.5% this year, and international economists reckon the true figure is probably much higher. Furthermore, the
government recently revised its estimate for full-year GDP growth to 11.4%, which means price levels may rise further, eating into the real value of the RMB. In fact, the OECD estimates that the Yuan remains undervalued by as much as 40% and views the “solution” as a combination of tighter monetary policy and looser exchange rate policy. The Associated Press reports:

While the report did not directly criticize China’s foreign exchange controls, it noted that efforts to tighten money supply to counter inflation were not having much impact.

Despite, or perhaps because of the appreciating Yuan, China’s trade surplus with the US is growing by 50% on an annualized basis, and is set to surpass $250 Billion for the year. In theory, the more expensive Chinese currency should reduce US dependence on Chinese exports and narrow the trade imbalance. In practice, the US is actually importing a greater quantity of goods and services from China and is also paying higher prices because of the appreciating Yuan. Ironically, the US Treasury Secretary is scheduled to discuss this matter with his Chinese counterpart next week, and is expected to pressure China to appreciate the RMB even faster against the Dollar. Unfortunately, China’s hands are partially tied as a result of an agreement it already signed with the EU, under which it promised to appreciate the RMB against the Euro. Bloomberg News reports:

Under the current regime, the yuan is allowed to move as much as 0.5 percent against the U.S. dollar every day, from the previous limit of 0.3 percent. "There will be a broadening of the trading band again in the next few months," said one analyst.

In the campaign to pressure China into revaluing the Yuan, the US has by far been the loudest voice. However, the rapid decline of the USD may have unintentionally earned the US a new ally in its fight: the EU. Since the Chinese Yuan is essentially pegged to the USD, and the USD has declined against the Euro, the law of triangular arbitrage is such that the Euro has actually appreciated significantly against the Chinese Yuan. EU officials are no longer standing by idly, since the exchange rate is beginning to deal serious harm to its balance of trade. In fact, the EU now occupies third position on the list of countries with the largest trade deficits with China. Because of the nature of China’s exchange rate regime, however, China’s ability to control the relationship of the Yuan with both the Euro and the USD will be difficult, if not impossible. The Bangkok Post reports:

Given the fact that about 70% of China’s $1.4 trillion in foreign reserves are dollar-denominated assets and the majority of foreign trade transactions are cleared in US dollars, China has focused more on the RMB-dollar rate.

In fact, China may have to increase its exposure to the dollar, according to the comments of Brad Setser of the Council of Foreign Relations: "In my mind, so long as China resists more rapid appreciation of the renminbi versus the dollar, it’s rather difficult for China to diversify in any meaningful way against the dollar. If China really started to diversify away from the dollar, I think it’s a big enough player that it would put downward additional pressure on the dollar."

And additional downard pressure on the USD should be what China is trying to avoid. China, being the largest exporter to the U.S. does not want to see appreciation of its currency against the USD, as that would make its goods more expensive (and therefore less competitive) in America.

In fact, Setser goes on to say that in order to prevent the USD from sliding even further downward against the RMB, China would have to not only retain its present stock of USD, but in fact buy even more.

A high-ranking official in China’s government recently gave a speech urging the Central Bank to (continue to) diversify its vast holdings of foreign exchange, currently estimated at $1.4 Trillion and rising. The speech was atypical in its level of directness, as Chinese officials tend to speak with a certain degree of circumspection if
they think there is any possibility that their comments will reach the public. Specifically, he advocated making a play on the current volatility in forex markets, by selling “weak currencies” in favor of “strong currencies.” In fact, the most recent data shows that China is already doing just that: its holdings of US government bonds have declined
even as its reserves have risen. The Financial Times reports:

Although he later tried to play down his comments, saying he had not been speaking in an official capacity, the damage was done.

The Chinese Yuan has crossed the psychological barrier of 7.5 RMB/USD, a level last seen nearly a decade ago. The currency’s appreciation has been gradual but visible, not withstanding the cries of western bureaucrats. By all accounts, the Yuan will continue rising, though not at the same pace as its trade surplus, which is projected to jump from $177 Billion in 2006 to $300 Billion in 2007. Predictions regarding the extent of the appreciation range from 20% to 400%, the implication being that it depends who you ask. But the general consensus is clear: the Yuan is pointing upwards. Bloomberg News reports:

Non-deliverable forward contracts show traders are betting the yuan will reach 7.0070 in 12 months, a gain of 6.9 percent from the spot rate, and 6.95 by the end of 2008.

You have to admire the US for its persistence in pressuring China to appreciate the Yuan, though it’s not as if anyone seriously expected it to back off. Fresh from the recent G8 conference and enjoying the spotlight of the media, US Treasury Secretary Hank Paulson called in China to put its money where its mouth is, and relax its hold on the Yuan. Paulson expressed dissatisfaction with the pace at which the Chinese currency has appreciated – approximately 10% since 2005. He even insinuated that there would be repercussions for the US-China trade relationship if this demand was not at least partially fulfilled. To add insult to injury, he warned that US public opinion of China is already at a low point, in the wake of the quality control issues with Chinese exports and the subsequent recalls. Reuters reports:

“While we are trying to lower barriers to trade, there is a risk that some in China are stepping away from long-standing policies of closer global economic integration — policies which have been a source of China’s incredible growth.”

Evidently frustrated by the Euro’s appreciation against the USD, a group of EU ministers has turned its attention to China, calling on it to allow the Yuan to appreciate against the Euro. While the Yuan has appreciated nearly 10% against the USD over the last two years, it has actually decreased in value against the Euro. As a result, the EU trade deficit has set a fresh record nearly every month. Unfortunately, the Yuan basically remains pegged to the USD, and since the USD is depreciating faster against the Euro than against the Chinese Yuan, the law of triangular arbitrage dictates the Euro must be appreciating against the Yuan. It appears China’s hands are tied. Bloomberg News reports:

“I can assure you China will continue to adopt a reform oriented policy on its exchange-rate mechanism,” said a Chinese Foreign Ministry spokesman. “But these
adjustments have to be done gradually and in line with the market.”

After much delay, China finally launched the bureau charged with diversifying its $1.4 trillion foreign exchange reserves. The agency will be capitalized with $200 billion and will invest in assets slightly more risky than US treasury securities. Most currency analysts view diversification as tantamount to the sale of dollar-denominated assets, but in practice, this may entail only the movement of funds into riskier dollar-denominated assets. In fact, the investment arm’s opening move was a $3 billion investment in The Blackstone Group, an American financial conglomerate. Dollar bulls can hold off on worrying just yet.

That the balance of trade between the US and China is becoming more and more lopsided in favor of China should come as no surprise to anyone. In fact, economists yawned when the August trade data revealed a 33% jump in the Chinese trade surplus. As a result, many are beginning to argue that China can allow the Yuan to appreciate at a faster pace against the Dollar, since it is obvious that China’s export sector will not be materially affected by a stronger Yuan. In addition, China now exports more goods and services to the EU than to America, yet another statistic which supports the notion that China can allow its currency to appreciate against the Dollar (the implication here being that the Euro-Yuan exchange rate should be more important to China at this point). Finally, China’s inflation rate is now hovering around 6.5%, its highest level in over a decade. A more valuable Yuan would presumably make imports less expensive, thus lowering prices across the board for Chinese consumers. Bloomberg News reports:

The Chinese currency is selling for about 7.51 to the dollar. It has risen almost 6 percent against the U.S. currency in the past year while falling more than 3 percent against the euro, leaving the overall competitiveness of China’s exports little changed.

Since it was freed from its fixed exchange rate regime two years ago, the Chinese Yuan has appreciated nearly 9% against the USD. While the Yuan’s exchange rate is clearly managed by the Chinese government, many commentators agree that its rise has given off the aura of a floating currency. One economist thinks China will cement this perception the conclusion of the Beijing Olympics-to be held in 2008-and allow the currency to float freely, at which point it could surge by as much as 10% against the USD. Evidently, China is growing tired of the lack of control it has over its domestic economy due to its exchange rate policy and is clearly overwhelmed by the need to continue growing its forex reserves (which now stand at $1.33 trillion) in order to control the Yuan. Bloomberg News reports:

“They have to adopt a free-float system; it’s not a question of whether they will, but a question of when. After the Olympics, the new leadership will be firmly in place.”

With the US government doggedly clinging to the notion that China is manipulating its currency and insisting that the communist country be punished accordingly, it bears asking “how can we determine that a currency (in this case the Yuan) is in fact undervalued, and if so, by how much. One notable economist has laid out three general techniques for “valuing a currency,” which may prove useful to all of you amateur economists.

First, there is the concept known as “purchasing power parity,” which suggests that a pair of currencies should fluctuate in value relative to each other based on changes in their respective interest rates and inflation. Second, there is the notion of a “sustainable” or “fundamental equilibrium” exchange rate which brings a country’s current account into balance- neither deficit nor surplus. Third, historical exchange rate data can be regressed against various economic indicators (productivity, employment, etc.) in order to distill the select few that had the most direct effect on the currency in the past. The most current economic data can then be plugged into the resulting equation and tested against actual exchange rates. However, while economists agree that these techniques are the most theoretically sound, they ignore the fact that currencies today seem less tied to the laws of plain economics than they do to financial economics- capital flows.

The Chinese Yuan refuses to die as a topic of conversation among forex speculators. In theory, the currency is among the world’s most prosaic; since its famous “revaluation” by the Chinese government nearly two years ago, the Yuan aka RMB has appreciated at a leisurely pace, roughly equivalent to 3% per year. Last week, the CCP took a step further in liberalizing its currency system by widening the band in which the Yuan is permitted to fluctuate, to .5% daily.

However, this did little to appease foreign diplomats and American politicians, who contend that the Yuan remains vastly undervalued, and that the Chinese government is guilty of currency manipulation. Two American Senators, Lindsey Graham and Charles Schumer, are still threatening to introduce a latent piece of legislation into Congress, which would slap a 27.5% tariff on all Chinese imports, unless the CCP promptly increases the value of the Yuan. (The 27.5% represents an average of the high and low estimates, 40% and 15%, respectively, of the extent of the Yuan’s undervaluation relative to the USD.) For its part, China maintains that not only is the currency fairly valued, but also that it will not be pressured into hastening the Yuan’s rate of appreciation. So, two questions need to be answered: Is the Yuan undervalued and if so, should China allow it to appreciate at a more rapid pace?

The first question is probably the trickier of the two to answer. Economists use admittedly crude techniques to value currencies. One method involves a calculation of purchasing power parity (PPP), which dictates that currencies should adjust in value relative to each other in inverse proportion to their respective price levels. In the case of the Yuan, PPP analysis suggests that the Yuan may be undervalued by as much 50%. However, this is to be expected; since income levels in China are vastly lower than in the US, one would expect prices to be lower, irrespective of exchange rates. Other methods used to estimate the fundamental value of the Yuan involve sophisticated statistical analysis, producing estimates of undervaluation ranging from 0% to 50%. In short, it appears as though the Yuan remains marginally undervalued, but the extent of which remains guesswork.

Upon concluding that the Yuan is undervalued, should China be expected to allow the currency to fluctuate more freely (i.e. appreciate)? It depends on who you ask. American officials argue that the revaluation of the Yuan represents a crucial piece of the drive to reduce the burgeoning US trade deficit. However, upon closer examination, this notion is revealed to be false since most of China’s exports to the US are themselves repackaged products from other parts of Asia. Further, a sudden revaluation of the Yuan would likely result in the relocation of Chinese production to facilities to other low-wage countries, thus doing little to stem the US trade deficit. From China’s point of view, its economy is helped by an artificially cheap currency in that its export sector receives an indirect subsidy. However, it is constrained in its ability to conduct monetary policy as well as in its need to accumulate massive forex reserves, both of which would be relaxed in the event of a revaluation.

Not withstanding that China’s stubbornness mean it will not be bullied into appreciating its currency, it is probably in everyone’s best interest if it capitulates. My prediction, for what it’s worth, is that China will ultimately allow the RMB to appreciate at a slightly faster pace against the USD, probably somewhere in the neighborhood of 5% a year.

China’s Central Bank recently made waves in forex markets when it created several state-owned organization charged with investing a portion of China’s $1.2 Trillion in forex reserves. Scant additional information was released until last week, when it was revealed that the first major investment would be a $3 Billion stake in The Blackstone Group, which is planning an Initial Public Offering. While it should be clear that China is taking its plan to diversify its reserves seriously, the news should come as a partial relief to Dollar Bulls, because in this case, the diversification will not involve the sale of USD.

In a sop to western policymakers, China recently announced that it would widen the Chinese Yuan’s daily trading band, from .3% to .5%. In theory, this means the Yuan will now be permitted to fluctuate by up to .5% per day against the USD. In practice, however, the Yuan’s daily rate of appreciation probably won’t exceed .05%, and only then on an especially volatile day. Two years ago, China revalued the Yuan and since then, the currency has appreciated at an annualized rate of 3%. However, the west was not mollified, and continued to pressure China relentlessly to allow the Yuan to appreciate further. Unfortunately for the west, this latest policy change is unlikely to have any practical impact on the valuation of the Yuan, as analysts are predicting the currency will appreciate by only another 3% this year. Bloomberg News reports:

The yuan never moved the maximum permitted under the previous limit. It moved 0.13 percent from the daily reference rate on April 16, the most this year, according to Bloomberg data.

Last fall, China’s reserves officially surpassed the $1 Trillion mark, a watershed event that would have been nearly unthinkable several years ago. This week, China announced that its reserves now exceed $1 Trillion, having grown by almost 40% year-over-year and showing no signs of slowing. Most of the increase can be attributable to growth in China’s trade surplus, which now exceeds $40 Billion, on a quarterly basis. China has already delegated the management of $250 Billion of its reserve to a state agency; perhaps this latest development will compel it to further delegate active management of the reserves. Xinhua News reports:

Continuous growth of forex reserve has in fact increased the pressure on appreciation of the Chinese currency, which in turn has exerted greater pressure on value preservation of China’s forex reserves, which are estimated to reach 2.9 trillion U.S. dollars in 2010.

To no one’s surprise, the Bank of Japan has announced that it would maintain Japanese interest rates at the current level of .25%. Carry traders seized upon the opportunity to continue borrowing Yen at near-record lows, and selling the Japanese currency in favor of higher-yielding alternatives. In fact, the news was met with such gusto that the Euro was almost immediately propelled to an all-time high against the Yen, which continues to plumb the depths of forex disfavor. At this point, analysts and economists are feeling fairly certain that Japanese interest rates will remain at current levels in the near-term, a sentiment which supports the viability of the carry trade. Forbes reports:

China, which recently unveiled plans to set up an agency under the aegis of the state that would manage the country’s surging forex reserves, is having second thoughts of sorts. While the plan to more actively manage its reserves remains on coarse, the likelihood that this result in diversification has been somewhat diminished. Estimates of the fraction of China’s reserves held in USD-denominated assets fall in the 70% range, which means that any decline in the USD could have multi-billion dollar ramifications for the value of China’s reserves. And surely diversification would put tremendous downward pressure on the USD, which means China would likely experience the offsetting of gains from diversification with the relative decline in the value of its USD-denominated assets. Forbes reports:

“Everyone knows that they should try to cut their US dollar assets. But, of course, if China wanted to make such a move, a big cut, our losses would be large as well. That would be very difficult to do.”

China’s Central Bank, in an effort to rein in the nation’s runaway economy, recently raised the country’s benchmark lending rate by 27 basis points. With most countries, an increase in interest rates would propel the country’s respective currency upward in value, as risk-averse investors would bring capital to that country’s bond markets. In the case of China, however, monetary policy tends to have a pretty negligible effect on the currency, primarily because the Yuan remains pegged to a basket, and its appreciation is being carefully managed by the government.

Several months ago, China announced that it would sponsor the creation of several state-owned investment firms that would be charged with managing China’s ever-growing stock of foreign exchange reserves. This week, China unveiled further details, indicating that the first one of these investment firms will be capitalized with $200-250 Billion in assets. This firm will use the proceeds of a bond offering for such an amount to buy forex reserves directly from China’s Treasury, with the explicit goal of earning a return in excess of the interest it must pay on the bonds. In order to achieve this, the firm will almost be forced to invest in non-USD denominated assets, which would surely exert downward pressure on the USD. The Shanghai Daily reports:

The State Administration of Foreign Exchange will run the daily operation of the country’s forex reserves, while the new forex investment company, under the State Council, will run the investment side.

China FX Firm to Manage $200 Billion+

The State Administration of Foreign Exchange will run the daily operation of the country’s forex reserves, while the new forex investment company, under the State Council, will run the investment side.

China recently announced plans to begin actively managing its foreign exchange reserves, currently valued at more than $1 Trillion. Concurrent with this announcement, China formally created The State Foreign Exchange Investment Company, which will initially be capitalized with more than $200 Billion. Another Chinese investment company will be given $100 Billion. These steps represent the culmination of several years of intense speculation that China would make more of an effort to manage its burgeoning reserves in order to maximize returns. Whether these two investment companies intend to diversify the reserves by investing in non-US assets is anyone’s guess, but at the very least, the US cannot be certain that China will continue to support the USD through its purchase of US Treasury bonds, which offer minimal yields.

The unthinkable has happened: China’s foreign exchange reserves have surpassed the historic level of $1 Trillion. Since the late 1990s, when China was continuously inundated with foreign direct investment, it has been forced to remove the foreign currency from circulation in order to mitigate the risk of inflation. Now, China has found itself in the unenviable position of managing the world’s largest cash reserves. As everyone knows by now, most of these reserves are held in USD-denominated assets, a phenomenon that has heretofore provided support for the USD while thoroughly muddling US bond markets. Imagine the effect on US capital markets if China decreased its USD holdings and invested the proceeds in its own economy. The Gulf News reports:

The composition of China’s reserves is secret, but economists believe about 70 per cent is in US Treasury bills, much of the rest in euros and a small amount in yen. Purchases of assets in other currencies are believed to be growing as the bank diversifies its holdings.

Since China revalued the Yuan in July 2005, the currency has appreciated by over 6% against the USD. Having since moved past the Hong Kong Dollar, the currency is showing no signs of slowing down. American politicians and trade representatives could not be happier. Their Chinese counterparts, on the other hand, are peeved. Many Chinese exporters have been forced to lower their prices in order to offset the rising yuan and maintain their competitiveness in overseas markets. Such exporters are complaining to anyone who will listen that a more expensive yuan is already eating into their profits. While China’s government prizes stability, it has not yet given any indication that it will halt the appreciation of the yuan in order to placate such malcontents. The Associated Press reports:

“When they started out on this process, they knew that some people would be hurt,” said Rothman. “If they can see the results are necessary to put the economy on a sounder footing long-term, then they can deal with the pain.”

Ignited by the threat of American trade sanctions and diplomatic pressure, the Chinese Yuan is now soaring against the USD. Last summer, it cleared through the psychological hurdle of 8 Yuan/USD and is now barreling towards 7.8. While this doesn’t strike most people as a significant milestone, the 7.8 barrier represents parity with the Hong Kong Dollar. Having traded below the HKD for nearly 13 years, the Yuan is now only weeks or even days away from overtaking its Hong Kong rival. In many ways, this event is symbolic of the broader economic Chinese economic explosion and its probable outstripping of the Hong Kong economy. Some analysts are predicting that when parity is breached, Hong Kong will immediately move to tie its currency to the Yuan, while others believe that the event will pass without much fanfare. The Financial Times reports:

Hong Kong-owned factories in China, long spoiled by renminbi-US dollar currency stability, are less than enthusiastic about the consequences of a stronger renminbi.

Last week, the Central Bank of Thailand implemented a series of draconian capital controls, designed to prevent foreign speculators from pouring funds into Thai capital markets and contributing to the appreciation of the Baht, which has been furious this year. Realizing this would ultimately be an inadequate means of grounding the Baht, Thailand has since added that an appreciation in the Chinese Yuan would take some of the upward pressure off of the Baht. Because the Yuan is effectively pegged to the USD, countries that run trade surpluses with the US and also have flexible exchange rate regimes (such as Thailand) must shoulder the brunt of the USD decline. The Wall Street Journal reports:

The Bank of Thailand [has since] removed capital controls on foreign investments specifically destined for the stock market. Controls on other investments remained in place.

Having recently surpassed the $1 Trillion mark and showing no signs of abating, China’s swollen forex reserves are in dire need of some serious management. China’s de facto pegging of the Yuan to the USD has forced it to segregate its foreign exchange reserves rather than inject them back into its economy. Meanwhile, a 100 basis point decrease in US interest rates costs China as much as $10 Billion annually in lost returns. As a result, China is now considering copying Singapore’s enormously successful model, in which Temasek, a government-funded company, makes billion-dollar investments in enterprises around the world. Whether a Chinese version of Temasek would lead to more or less USD-denominated investments is anyone’s guess, as Forbes reports:

China funded a study trip around Asia earlier this year looking at how various governments manage their reserves, including Singapore. The massive growth of China’s foreign exchange reserves has triggered calls for their holdings to be diversified and put to better use.

Last week, a well-respected Japanese economist publicly urged Asian nations to take joint action in accepting the fall of the USD against their respective currencies. He encouraged them to fight the temptation to intervene in forex markets, because such could potentially cause massive instability. Most Asian nations would lose on two fronts of the USD continued to decline; their economies would suffer due to less competitive exports, and their USD-denominated reserves would become relatively less valuable. However, it seems that most of these countries could withstand a 20% decline in the USD, despite any negative short term fallout. The New York Times reports:

“It would be very difficult to achieve such coordination. However, we have seen Asia coordinate in some areas where they normally compete, such as when India and China bid for foreign energy assets.”

As China’s FX reserves soar past the $1 Trillion mark, the country may begin taking the management of these reserves a little more seriously. In the past, China merely issued Yuan to those in possession of foreign currency, and then proceeded to remove the currency from circulation and stash it in risk-free investments overseas. Now, however, China’s reserves are so gargantuan that it risks losing out on billions in potential profits by failing to intelligently invest and diversify its holdings. As one would expect, reconfiguring these reserves would involve not only investing in different types of securities, but also in many different currencies, steps which have serious implications for world forex and capital markets. AFX News reports:

The finance ministry [could] issue 200-400 bln yuan worth of bonds with maturities of at least 10 years. The bond proceeds can be used to buy foreign currencies from the central bank which may then be invested in overseas markets.

Over the last few months, the Chinese Yuan has picked up its pace of acceleration, to such an extent that it is now rising by an annualized rate of 7%. This has spurred two points of speculation: first, for how long will the Yuan continue to rise at this pace and second, will Hong Kong link its Dollar currency (HKD) to the Yuan? The answer to both questions is ‘probably not.’ The Yuan’s current rise is probably a conciliatory gesture to carping foreigners. With regard to the second question, Hong Kong is probably not likely to peg its currency to the Yuan because currency stability is important to its position as one of the world’s foremost financial hubs. In addition, Hong Kong is not subject to the level of international pressure that plagues its counterpart, so there is no real incentive for it to link its currency to the rising Yuan. The Economist reports:

As Hong Kong and mainland China become more economically and financially integrated, it seems inevitable that the Hong Kong Dollar will eventually be replaced by the Yuan. However, a merger will not make sense until the Yuan becomes fully convertible.

Chinese governmental officials have been somewhat quiet about the Chinese Yuan of late, perhaps not wanting to incite certain American politicians that are trying to lead the passage of a tariff on Chinese imports. In a recent press conference, officials broke the silence by hinting that the Yuan would witness an “accumulated slight revaluation”- meaningless rhetoric which translates roughly into ‘business as usual.’ In other words, barring some unforeseen economic or financial developments, forex traders can probably expect a 2-3% appreciation of the Yuan in 2007.

Last week, I wrote a commentary piece on the implications of the burgeoning global stock of forex reserves, the most pressing of which is the risk that the USD will plummet when/if countries decide to diversify their reserves into other currencies. Perhaps in response to my posting, an advisor to China’s Central Bank commented today that diversification would be a difficult task. He identified the Japanese Yen and the Euro as viable alternatives, but insisted that because the US was China’s primary trade partner, it makes sense for China to hold its reserves in USD-denominated assets. If the USD falls, as many expect it will, China will compensate by allowing the Yuan to depreciate proportionately. Forbes reports:

“If there’s a hard landing in the US and the dollar plunges, and we maintain a managed floating system, the yuan will fall along with the US dollar.”

This month, the locomotive that is China’s stockpile of forex reserves surged ahead, to $954 Billion, with economists now predicting that the $1 Trillion mark will be breached in October. Export-dependent countries-notably China and Japan- have accumulated gargantuan reserves over the last decade, as an alternative to allowing their currencies to appreciate. In most countries, Central Banks take the currency that foreigners used to pay exporters, and allow it to circulate in the economy. China and Japan have instead taken to hoarding their reserves in order to decrease demand and thud hold down the value of the Yuan and Yen, respectively. The Asia Times Online reports:

More foreign-exchange reserve demands more hedging money in local currency, which may weaken the controlling capacity of China’s monetary policy, impose pressure on the appreciation of the yuan, and exacerbate foreign-trade frictions.

A couple weeks ago, I posted on this very subject- that the value of the Chinese Yuan is largely tied to inflation and interest rate differentials. With this week’s commentary piece, I wish to further expound upon this theory, because it appears to really carry weight. Most traders who have an opinion on the Chinese Yuan base their forecasts for the Yuan’s appreciation on political developments: how much diplomatic pressure the world will apply to China and how much China will capitulate on this most delicate of economic issues. A Stanford economist, however, has demonstrated that political guesswork might not be necessary, by connecting the Yuan’s appreciation to several important economic indicators.

Let me explain. There are two closely related theories in classical economics which attempt to account for changes in the relative value of currencies: interest-rate parity and purchasing power parity. The theories hold that the relative value of a nation’s currency should move inversely with price levels and interest rates, respectively. The reasoning is straightforward enough: the return on risk-free investments denominated in two different currencies should be equal in order for the markets to clear. However, as in many areas of economics, the gap between theory and reality in currency markets is significant, for high interest rates often attract risk-averse foreign investors instead of repelling them, which ultimately leads to the currency increasing in value.

In contrast, the Stanford economist seems to have established that the laws of parity seem to be holding in the case of the Chinese Yuan. It turns out the China-US inflation and interest rate differentials have almost perfectly mirrored the movement of the Yuan in the past year. As growth in the US began to drive inflation, the Fed raised interest rates to the extent that they currently exceed Chinese rates by over 3.5%- the precise amount by which the Chinese Yuan has appreciated against the USD this year! This phenomenon indicates that the Central Bank has allowed the Yuan to appreciate only so much as to offset the value by which the USD has been eroded by inflation. Coincidence? Probably Not. In short, we should expect the Yuan to appreciate only by the amount that American price and interest rate levels exceed those of China.

For the first time, officials from China’s Central Bank will meet publicly with their counterparts in Japan, a nation that knows a thing or two about currency appreciation. Over 20 years ago, the world’s industrialized nations signed the Plaza Accord Agreement, which laid out a plan for devaluation of the USD against the Japanese Yen. The purpose of the agreement was to help the US stem its current account deficit and simultaneously emerge from an economic recession. [Note the similar circumstances which currently surround the attempt by the US to depreciate the USD against the Yuan.] Anyway, the result of the agreement was a Japanese recession, and ultimately, an asset price bubble which continues to plague Japan to this day. Chinese officials hope to learn from Japan’s travails and avert a similar economic implosion.

China’s foreign exchange reserves may soon surpass the mystical threshold of $1 trillion. This month, they soared to $950 Billion, as China’s current account surplus was promptly reinvested in foreign securities. If China allowed the new Yuan to circulate in the money supply, the result would be double-digit inflation. Instead, China holds all of the surplus yuan in the form of foreign currency, a habit which exerts severe upward pressure on the yuan and may soon overwhelm China’s monetary system to the point where it has no choice but to allow the yuan to appreciate. China Daily reports:

“We will take comprehensive measures to avoid further significant growth in the foreign exchange reserves,” said the vice president of China’s Central Bank.

While interest rate differentials have been closely linked to relative values of the USD, Euro, and Japanese Yen, most people never figured the hot topic would ever be applied to the Chinese Yuan. After all, few international investors seriously care about interest rates in China, right? One economist, however, has established a strong relationship between the China-US interest rate differential and the value of the Chinese Yuan. Specifically, he figures that the Yuan’s annual appreciation will equal or come close to equaling the difference in American and Chinese interest rate levels. His reasoning is that those who invest in Chinese assets require a return equal to the yield on comparable US investments. Since American interest rates are currently 3.3% above Chinese interest rates, he theorizes that the Yuan will appreciate 3.3% this year to make up the difference. The Wall Street Journal reports:

The bottom line is that China’s Central Bank must carefully watch inflation and interest rates in the U.S. when formulating its own exchange-rate-based monetary policy.

Charting the value of the Chinese Yuan (RMB) against the USD reveals the currency is appreciating at a snail’s pace. When you add volatility to the chart, the story becomes less black-and-white. Over the last six months, the RMB has begun to test the limits of the .3% daily trading band imposed on it by China’s Central Bank. Now, the currency routinely gains or loses .2% in a single day. While the gains have largely been offset by losses, this is still a positive development because it shows China is slowly moving towards a point in which the Yuan is allowed to freely fluctuate against the USD. China is certainly not going to capitulate to western interests by drastically revaluing its currency; rather, it will continue to move slowly and test the waters, until it is clear that China’s economic and financial infrastructure can accommodate a floating currency. The Economist reports:

[HSBC] puts weight on a recent statement by …the central bank’s monetary policy committee, that China could cope with an annual appreciation of 5%. That’s slower than America would like—but about as fast as it can expect.

With my first commentary piece, I would like to address several issues concerning the Chinese Yuan. Let me begin by saying there is a tremendous amount of information and a wide array of often-conflicting opinions surrounding the Chinese Yuan. The problem with most financial analysts is that they often fail to grasp the big picture: in this case, the determinants of the Chinese Yuan’s value are multifarious, and take in financial, economic, and political factors, which most analysts fail to consider.

As most of you are probably aware, the Chinese Yuan has appreciated over 3.5% in the last year, including the 2.1% revaluation that the Chinese government effected last July. Many economists insist the Yuan is still undervalued by 35%, a figure that politicians love to quote. Analysts have also backed this estimate and incorporated it into their models that predict the Yuan will appreciate by 5% this year. You can look at RMB currency futures for proof that this is indeed the consensus forecast.

Both of these figures are ill-conceived and downright misleading. First of all, while the Yuan could clearly stand to appreciate, the extent to which it’s undervalued is probably closer to 10-15%. A true estimate of the Yuan’s fair value must make adjustments for inflation in order to account for differences in purchasing power. As China’s economy has expanded, inflation has grown at a proportional rate, eroding the value of the Yuan. At this point, China’s ability to produce cheap goods is probably more closely related to a surplus of unskilled labor and free capital, than to an undervalued currency.

Secondly, and just as important, is the fact that China will likely continue to appreciate the Yuan at its own pace. On several occasions, Chinese political leaders have invoked an ancient Chinese proverb when discussing the revaluation of the Yuan. The proverb states that one should take small steps in this type of situation. Whether China is genuinely nervous about revaluing or whether it simply wants to keep benefiting from an undervalued currency is anyone’s guess. What is not debatable is China’s stubbornness, reflected in its refusal to bow to western pressure when shaping its economic policy. In short, when an analyst tells you that the Yuan will appreciate by more than 3% this year, you should react with skepticism.

In the last two months, the Chinese Yuan has soared by nearly .6% against the USD. Compare that with the 1.2% that the Yuan appreciated in the prior 10 months, and an interesting picture begins to emerge: is China finally relaxing its control over the Yuan, allowing its value to be determined by market forces? The short answer is ‘no,’ but the long answer is ‘yes.’ Specifically, the last two months represent a sop to international economists and western politicians, who have hinted that China’s failure to continue ‘revaluing’ its currency would bring about negative consequences for its economy. While China is nowhere near letting the Yuan float freely against the basket of currencies it is currently pegged to, the last two months were certainly a small step in that direction. The Shanghai Daily News reports:

“The central bank is likely to follow up with …faster yuan appreciation through widening the yuan/dollar trading band, said the chief economist at Goldman Sachs Asia.

China’s foreign exchange reserves are currently the largest in the world; analysts are predicting they may soon surpass one trillion dollars. The majority of the reserves have long been parked in USD-denominated assets, mostly Treasury securities. Because the RMB is slowly appreciating against the USD, when China converts these securities back into Yuan, it will incur massive losses. Further, the longer it waits-assuming the Yuan continues to appreciate in value-the larger China’s losses will be. For this reason, China’s National Bureau of Statistics is recommending for it to begin transferring some of its holdings into assets denominated in other currencies and mitigate its foreign exchange risk. Since China’s reserves are so large, any move away from the USD would have significant fallout in forex markets.

The National Bureau of Statistics warned against the exchange risk associated with tying too much money up in assets denominated in a single currency which threatens to steadily decrease the value of the reserves

This month marks the one-year anniversary of China’s revaluation of its currency. At the time, commentators and economists predicted China would continue to incrementally revalue its currency, and gradually move towards a market-based exchange rate. In reality, the Yuan has appreciated by less than 1.5% against the USD, and American business interests are once again calling for blood. The American political establishment has responded by introducing a new strategy, one that involves offering China a greater role on the geopolitical stage in return for dismantling the de facto peg to the USD. Specifically, the US may help China negotiate a larger share in the International Monetary Fund (IMF), so that it will have a greater ability to influence decision making. The Wall Street Journal reports:

The IMF has been trying to get China-and by extension South Korea, Taiwan, and some other Asian nations that track China’s exchange rate- to reduce their reliance on weak-currency driven exports.

Earlier today, China announced that the minimum amount that banks must place with the central bank will be increased by 0.5% beginning August 15. This reserve requirement increase caused the yen to reach its one-week high against the USD. It came as a disappointment to Washington however that there was no further discussion of yuan flexibility, but it is likely that this debate will heat up in the coming weeks and months. Forbes reports:

Bank of New York currency analyst Neil Mellor noted that Ba Shusong, an influential government economist said today that China needs to widen the yuan’s trading band to help control excess liquidity.

A further widening of the trading band ‘could easily come within the next few weeks,’ Mellor reckoned.

A year ago, China adjusted the yuan by 2.1% versus the dollar and allowed it to float within tight bands. Still, US economists believe that the yuan remains grossly undervalued and want it to be able to float more freely. The US trade deficit with China hit $202 billion last year, perhaps largely due to the yuan being so undervalued. Wei Benhua spoke at a press conference in Paris earlier today and indicated that China still needs more time to assess the yuan reform. According to Wei, via the Gulf Times, the management of forex reserves are carried out under three guidelines:

First is to maintain the liquidity of reserves. We need to have liquid reserves. The second principle is the safety of our reserves — we want to be very secure. The third is profitability. After you meet the first requirements, you want as much profit as possible.

Last week, the Treasury Department released its semi-annual report on exchange rates. The report stopped short of accusing China of being a “currency manipulator”. Now, Secretary John Snow is under fire from Congress. Finding China’s currency to be intentionally overvalued against the USD most likely would have triggered talks between the US and China and possibly led to economic sanctions. By not making such a claim, the Treasury has invited criticism from Sens. Charles Schumer and Lindsey Graham, who are sponsoring legislation that would impose high tariffs on China should it fail to adjust its currency. Most economists believe that the Chinese yuan is overvalued by anywhere between 15% to 40% against the dollar. The Washington Post reports:

Sen. Charles Schumer, D-N.Y., said Treasury’s report last week that declined to brand China as a currency manipulator was “a technical and legalistic dodge.” “China is a manipulator,” Schumer said at a Senate Banking Committee hearing, “and the administration is afraid to say so.”

The eagerly awaited semi-annual Treasury report on exchange rates has finally been released, and the results may have serious implications. Many members of Congress, among others, had been hoping the US would use the report to officially label China a currency manipulator, which would justify the use of trade sanctions and other economic penalties. Instead, while admitting it was concerned about widening economic balances engendered by China’s artificially low exchange rate, the Treasury Department stopped short of formally accusing China of currency manipulation. The report may provide the impetus to propel a bill, which would punish China economically, through Congress. The New York Times reports:

They [Senators Schumer and Graham] can be expected to challenge the Treasury report’s conclusion, but they have also kept their bill calling for tariffs on hold while watching how China responds.

Earlier this year, US Senators Charles Schumer and Lindsey Graham proposed a bill that would slap a 27.5% tariff on all Chinese imports, in the event that China failed to revalue the Yuan in a timely manner. After meeting with senior Chinese banking officials, however, the Senators agreed to postpone voting on the bill. This week marked another about-face, as they publicly announced that the bill would be reintroduced at the end of the year if China does not allow the Yuan to appreciate 7-10%, in a demonstration that they take US relations seriously. The Washington Post reports:

“My hope is that between now and the end of the year you will have a revaluation somewhere in the double-digit area,” said Sen. Lindsey Graham.

China caught investors by surprise last week, when it raised its benchmark interest rate for the first time in years, to 5.85%. Foreign banks applauded the move as emblematic of China’s broader effort to allow market forces to play a larger role in the economy. China must tread carefully, however, as the Yuan-USD peg severely constrains its ability to conduct monetary policy. If China’s Central Bank wishes to raise rates further (to rein in growth and inflation), it may have to allow the Yuan to appreciate at a faster pace, so as not to invite an influx of speculative capital. Reuters reports:

U.S. officials will consider all of the steps China has taken to retool its economy when assessing the nation in a semiannual report on whether U.S. trading partners manipulate exchange rates to gain unfair trade advantage.

The G7 Industrialized nations recently called on China to afford the Yuan increased flexibility. Many pundits likened the comments to similar exhortations made several years ago (regarding increased Euro flexibility). After that announcement, the USD declined over 10% against most major currencies within one year’s time. Will a similar fate befall the USD this time around? It seems likely, as the G7’s comments may ultimately pave the way for equally serious words of encouragement by America’s Treasury Department, in its semiannual currency report. AME Info reports:

For the very first time ever, China has been mentioned directly by the G7, reflecting their increased concern over the past few months.

Last week, the World Trade Organization (WTO) became the most recent addition to the chorus of voices calling for revaluation of the Yuan. The most prominent advocates of Yuan revaluation, which include the United States, European Union, Japan, and the International Monetary Fund had previously invoked the correction of global imbalances as the prime justification for reform. The WTO, in contrast, is encouraging revaluation on the grounds that it will enable China to conduct an independent monetary policy and control inflation. The Financial Express reports:

The yuan on Wednesday rose the most against the dollar since a revaluation in July, following speculation that pressure from US President George W Bush and strengthening Asian currencies will force China to allow faster gains.

This week, China announced it would officially do away with caps on capital outflows. Previously, a business or retail investor wishing to exchange Yuan for foreign currency had to petition the government to do so. Moreover, the amount of currency that could be exchanged was capped at a low value. With this latest move, China has signaled that it is ready to move towards a floating currency system, in which individuals would be free to buy and sell as much Chinese currency as they wished. In the short run, this should help to reduce some of the upward pressure on the Yuan. Xinhua News reports:

The government…made it easier for individuals and firms to buy foreign currency and invest abroad, including allowing domestic banks to invest in financial products outside the mainland.

This week, Hu JinTao, Prime Minister of China, will visit the United States for the first time since he assumed power. As you probably guessed, the Yuan will be a hot topic of conversation between Chinese and American officials. It bears mentioning that American politicians continue to call for a 25% increase in the value of the Yuan, as economists feel the Yuan is undervalued. However, forex markets reflect slightly different expectations with regard to the path of the Yuan. Specifically, Yuan currency futures indicate investors believe the Yuan will only appreciate 2.8% this year. Non-deliverable Yuan forward contracts, which serve a similar purpose, have priced in a 3.1% gain. While there remain a few analysts that believe the Yuan will rack up double digit gains against the USD this year, the majority of traders expect the Yuan to continue appreciating gradually. Reuters reports:

JP Morgan…expects the dollar to fall to 7.00 yuan by the end of this year, but admits that the market is pricing in less than a 2 percent chance of this occurring.

It’s official: the US is no longer alone it its exhortation of China to further revalue the Yuan. In a press conference held earlier this week, the Finance Minister of Austria (the nation that currently holds the rotating presidency of the EU) suggested that the Yuan must be allowed to appreciate. He argued that such a step was not only in the long-term of interest of China, but would also help correct global economic imbalances. His calls for revaluation closely mimicked those of the US, with one notable difference. The Finance Minister insisted that the Yuan revaluation should be accomplished gradually, whereas American politicians would like to see it take place in one swift motion. AFX Limited reports:

The EU Commission reportedly backs a more gradual approach because of concerns that sudden yuan adjustment could weaken the dollar against the euro.

While the last few months have witnessed rising talk of forex reserve diversification, China seems intent on preserving the status quo. Representatives from China’s Central Bank recently announced that the nation’s foreign exchange reserves, which are already the largest in the world, would likely grow by at least $100 Billion in 2006. This is due both to the soaring current account surplus and the vast sums of foreign capital that continue to be invested in China. Further, the bulk of these new reserves will likely be held in USD-denominated assets, which are valued for their liquidity. Forbes reports:

Xinhua quoted Cao as saying that it would be unwise for China to sell off its dollar assets because they are still the most reliable assets in the world.

It was probably inevitable: China’s foreign exchange reserves are now the largest in the world, having recently surpassed $850 Billion. The reserves are both a product of China’s massive current account surplus and the $100 Billion+ that the nation attracts in foreign investment each year. Further, experts do not expect China to slow its accumulation of reserves, which may reach $1 Trillion by the end of the year. As the majority of China’s forex reserves are held in USD-denominated assets, any slight appreciation of the Yuan causes a relative depreciation in the value of its reserves. Rediff.com reports:

China’s forex reserves maintained an upward growing trend and would be beneficial to maintain the nation’s and its enterprises’ external credit and the stability of financial structure and to prevent and resolve international financial risks.

Earlier this week, US Senators Charles Schumer and Lindsey Graham concluded a trip to China, during which they met with top-level Chinese officials to discuss economic issues. The most important item on their agenda, naturally, was to press China to further revalue the Yuan. In less than a week, in fact, the Senate is set to vote on whether Schumer’s bill, which calls for a 27.5% tariff to be levied on all Chinese imports, should be advanced. Evidently, Senators Schumer and Graham left the talks satisfied, indicating that the Yuan should likely break through a level of psychological importance in the near future. The China Daily reports:

Premier Wen Jiabao said eight days ago that the range for the yuan’s fluctuation would be widen. But there will not be a one-off revaluation like the one in July, he said.

In a recent interview, the always-coy Chairman of China’s Central Bank hinted that China may widen of the band in which the Chinese Yuan is permitted to move. The current band allows the Yuan to fluctuate +/- .3% per day, although in practice, the currency rarely moves by more than .01% per day. The Chairman was adamant, however, that China would not execute another one-off revaluation of the Yuan, like it did last summer. Rather, the RMB will continue to appreciate gradually, so as not to shock the global economy. Reuters reports:

Chinese officials have recently pledged to gradually increase the yuan’s flexibility by making better use of its daily trading band rather than doing another one-off revaluation.

Since China famously revalued the Yuan last summer, trade lobbyists and protectionists have continued to urge the Bush administration to pressure China on its exchange rate policy. In a sign that it may be bowing to popular demand, the US Treasury Department recently announced it may officially label China a ‘currency manipulator,’ in its biannual report to be released in April. The label would provide a basis for trade and economic sanctions. Chinese officials have considered the possibility of such an accusation, but continue to maintain that the Yuan will be adjusted at China’s pace. This is not surprising, as China’s exchange rate policy is determined at the highest level of political decision-making. The Wall Street Journal reports:

Chinese exchange-rate policy will be guided not by politics but by calculations on how any changes will affect domestic growth. “Nobody thinks” the U.S. will label it a currency manipulator, which would require formal talks with China on the issue.

Over the last few years, so-called ‘hot-money’ has poured into China, as investors sought to capitalize on a revaluation of the Chinese Yuan. In order to prevent these capital inflows from exerting severe upward pressure on the Yuan, China’s Central Bank was forced to turn around and buy USD. Since the US began raising interest rates, however, inflows of hot-money have declined, as the opportunity cost of waiting for a revaluation has increased. As a result, representatives from China’s Central Bank were excited to announce that managing the de-facto Yuan peg has become easier, much to the dismay of Western policy-makers. Bloomberg News reports:

The U.S. Treasury refrained from naming China a currency manipulator in a twice-yearly review of trading partners’ exchange-rate policies released on Nov. 28. The next report is due April 15.

This week witnessed several important developments in China’s efforts to eventually allow the Chinese Yuan to float freely. First, China announced it may soon allow interest rates to fluctuate in accordance with market forces, rather than rigidly controlling rates. In response, one of China’s largest banks announced the completion of China’s first ever interest rate swap agreement, which serves as a proxy for expectations surrounding future interest rates. These developments are important because higher interest rates would surely put strong upward pressure on the Yuan. Meanwhile, the Yuan has continued to appreciate in forex markets (albeit slowly), and is on pace to breakthrough 8.05 RMB/USD next week.

At this week’s World Economic Forum, which is being held in Davos, Switzerland, China has predictably held center stage. Not all of the attention has been positive, however, as the US has used the Forum as an opportunity to lambaste China for its stubborn to further revalue its currency. Since last July, the Yuan has appreciated 2.5%, which is much less than what Western policymakers had hoped for. While senior US Treasury officials publicly rejected applying pressure to China via tariffs and other trade sanctions, they were adamant that China move forward on its plans to appreciate the Yuan, as it now has the financial infrastructure to support a more flexible currency regime. Reuters reports:

Economists at a session on the global economy in Davos, however, pointed out that the United States and China have a symbiotic relationship and that U.S. pressure for rapid revaluation might be misplaced.

On paper, the case for a revaluation of the Chinese Yuan seems rock solid: China’s forex reserves have swollen to $800 Billion, its annual trade surplus exceeds $100 Billion, and its exports have soared. However, delve deeper into the figures, and a vastly different picture emerges. First, the country’s forex reserves are largely the result of ‘hot money,’ inflows of foreign capital hoping to instantaneously capitalize on a Yuan revaluation, rather than long term investment in capital projects. In addition, China’s trade surplus is increasingly a story of slowing imports, rather than growing exports. As investment in fixed capacity has declined, so has the demand for equipment and machinery, much of which is imported. In addition, while China’s trade surplus with the US exceeded $200 Billion in 2005, China runs a deficit with most other countries it trades with. The Economist reports:

So the balancing act, for the [Chinese] authorities, is to keep up the expectation of a revaluation through talk and an exchange rate that crawls up fractionally—by another percent or two here or there.

Last year, over $300 Billion in currencies were traded via China’s foreign exchange market. 98% of this trade, however, involved China’s official interbank market, in which buyers and sellers are matched up in a centralized system. This will soon change, however, as China prepares to open the new market, in which currency trading will be facilitated by 13 banks, including five that are foreign. The Central Bank will continue to set the so-called parity price and control the Yuan exchange rate via calculated intervention. However, as part of the new system, private market-makers will have more discretion in setting prices, which could spur further Yuan appreciation. AFX News limited reports:

One analyst noted that current prices are not necessarily indicative of future trends on the two markets. “The key thing is now is they’ve got a market. People are going to push the envelope a little bit and…test the limits a little bit more,” he said.

Last week, officials from China’s Central Bank announced that they would “actively explore more effective ways to utilize [forex] reserve assets.” Many analysts interpreted this remark as an explicit signal that China would begin ‘diversifying’ its foreign exchange reserves, by holding fewer USD and more of other currencies. However, as the speculation began to reach fever pitch, the same group of officials announced that their previous statement had been misinterpreted. In fact, existing USD reserves play a vital role in helping China maintain its peg to the USD. Accordingly, any ‘diversification’ will only affect new reserves. The Daily Times reports:

“The general trend is that every country wants to diversify its reserves. No one is willing to put all of their eggs in one basket and it is impossible for China to put all its forex reserves, which exceed $800 billion, in one currency.”

Earlier this week, the Bank of China issued permits to several foreign and domestic banks, which enable them to serve as market-makers for the Chinese Yuan. Yesterday, the Bank of China further explained the new system, stating that the Yuan’s daily opening price would be calculated based on an average of spot rates offered by 13 market-makers. While the Bank of China, through its forex reserves, could still technically manipulate the value of the Yuan, this latest development makes it more likely that the Yuan will be allowed to appreciate in 2006. In fact, futures markets have priced in a 4.3% appreciation for the entire year. Some currency strategists are even more bullish, as the Financial Times reports:

We remain convinced further renminbi strength is highly likely,” said Thomas Stolper, global markets economist at Goldman Sachs, who sees the renminbi rising 9 per cent to Rmb7.34 to the dollar by the end of 2006.

In a move that is sure to turn a few heads, China will soon allow over-the-counter trading in its Yuan currency. In addition, several domestic banks and a few foreign banks have been awarded market-maker status in the new system, which legally enables them to buy and sell Yuan to market participants. Previously, only large financial institutions were permitted to trade the Yuan, via the interbank market. While the Yuan will still be prevented from fluctuating by more than .3% per day, critics of China’s fixed currency regime have hailed the move as a step towards a floating currency. The Financial Express reports:

Effective from Jan. 4, the central bank would authorise the China Foreign Exchange Trade System to announce the central parity of the yuan exchange rate against the dollar, the euro, the Japanese yen and HK dollar at 0115 GMT each day.

Several weeks ago, Chinese officials suddenly announced they had reason to believe China’s economy is much larger than past GDP figures indicate, and they immediately began amassing data and building models to prove their point. Yesterday, the same group of officials released a revised set of GDP figures, which raised the value of China’s economy by 17% and catapulted the country into 6th place in global nominal GDP rankings. Apparently, past GDP calculations had grossly underestimated the size of China’s booming service sector, which represents 41% of China’s economy. In addition, the new GDP figures reveal that fixed asset investment is actually at a sustainable level. In short, China’s economy is both larger and more structurally sound than previously believed. The Financial Times reports:

The new, more rosy picture of economic strength could fuel calls from the US for China to revalue significantly its currency, which critics say is being held at a level that grants an unfair trade advantage.

In theory, the Chinese Yuan can fluctuate (read appreciate) by .3% per day. In reality, the Central Bank allows the currency to appreciate by less than .01% per day, which has limited the Yuan’s net appreciation against the USD to only .4% since the 2.1% revaluation in July. As a result, the G8 governments are clamoring with renewed vigor for China to further revalue. In fact, a rumor has been circulating that China will widen the Yuan’s daily trading bands to 1%, which would enable the currency to appreciate faster. Many analysts expect the Central Bank to announce such a move before the Chinese New Year on January 29th. Bloomberg News reports:

“Given the track record of the Chinese government preferring to announce key policy changes ahead of long holidays, it’s convenient for the market to anticipate the next key move on the renminbi could come in the later half of January,” said one analyst.

A leading adviser to China’s Central Bank recently confirmed what many analysts have suspected for months: a revaluation of the Yuan or RenMinBi will likely take place over the course of the next 1-2 years. The advisor publicly warned Chinese firms to make the necessary adjustments, in order to prevent the revaluation of the Yuan from severely harming their prospects for success. While not indicating the size of the revaluation, Yu Yongding hinted that it would be significant, in order to help China rein in its burgeoning trade surplus. Reuters News reports:

He said China’s big current account surplus, just like the large U.S. current account deficit, fundamentally reflected savings-investment imbalances in the two countries. “The rise in the renminbi’s exchange rate will definitely have an impact on China’s trade surplus.”

The US Treasury Department finally released its annual currency report; which contained a notable absence: China. Politicians and lobbyists were outraged that the Bush Administration did use the report to formally accuse China of manipulating its currency. Senators Schumer and Graham are already threatening to reintroduce a bill that would slap a 27.5% tariff on all imports from China. Secretary of the Treasury, John Snow, tried to brush off criticism that the administration was being too soft on China, by publicly urging China to move forward on plans to continue adjusting the Yuan, which has appreciated only .3% in the last four months. The Associated Press reports:

We are looking to Congress,” Tonelson said. “It is clearer than ever that America’s domestic manufacturers cannot count on any help from the White House to remedy this totally unacceptable situation.”

Perhaps in response to recent pressure from American politicians and the IMF, the Central Bank of China made another push towards floating the Yuan by introducing foreign exchange swaps. Swaps function like futures, by enabling partied to buy and sell currencies at a fixed exchange rate on a fixed date in the future. In this case, the Central Bank has agreed to buy USD one year from now at a rate of 7.85 Yuan/USD. Investors and analysts are speculating that the swaps lend explicit insight into where the Central Bank believes the Yuan will be in one year. Non-deliverable forward contracts, which indicate collective investor expectations for the future value of the Yuan, are currently priced at 7.78 Yuan/USD. The China Daily reports:

Late Thursday, China’s State Administration for Foreign Exchange announced it would also introduce a new currency trading system allowing interbank market members to trade directly with each other.

Last week, this correspondent reported that American politicians, frustrated by their inability to convince China to further revalue the Yuan, were planning on using the IMF as a vehicle for applying pressure to China. Yesterday, the IMF fulfilled this request during a conference call with Chinese officials. IMF representatives referred to the Yuan’s marginal .33% rise since the July revaluation in their plea for China to allow its currency to respond to market forces. Apparently, the IMF has been working closely with Chinese officials since 1999 on issues related to foreign exchange. The organization now feels China has the necessary infrastructure in place to support a more flexible Yuan. Reuters News reports:

“Greater exchange rate flexibility would contribute to rebalancing the composition of economic growth…and potentially raising consumption by boosting households’ real income,” said the director of the IMF’s Asia-Pacific department.

Despite its best efforts, the US has not any success in convincing China to further appreciate the Yuan, since the monumental revaluation in July. Meanwhile, American politicians are toying with the idea of legislating a tariff on all Chinese imports, and trade groups are lobbying for the Treasury Department to officially label China a ‘serial currency manipulator.’ Lately, however, those in favor of Yuan revaluation have embarked on a new strategy, by attempting to enlist the help of the IMF (International Monetary Fund) in applying economic and diplomatic pressure to China. They are suggesting the IMF use its clout to hold a special economic consultation with Chinese officials, and demonstrate that it is in the best interest of everyone that China further loosens the Yuan. The Wall Street Journal reports:

“Movement to a market based exchange rate would be in [China’s] interests,” Deputy Treasury Secretary Robert Kimmit said in an interview. “It would also serve our-and global- interests.”

Next week, George Bush will visit China as part of his week-long junket to Asia, in which it is expected he will personally urge Hu Jintao, Prime Minister of China, to continue revaluing his nation’s currency. Bush is under pressure from unions and trade lobbyists, who allege China’s artificially cheap currency is responsible for the outsourcing of millions of jobs. American politicians are demanding that Bush give China an ultimatum: either revalue, or face the consequences, in the form of tariffs and other trade restrictions. In addition, the Treasury Department was supposed to release a report on currencies last month, in which China would likely be labeled a ‘currency manipulator,’ but has delayed the release of the report until after Bush returns from his visit.

“I will remind him that this government believes they should continue to advance toward market-based evaluation of their currency for the sake of the world, not just for the sake of bilateral relations,” Mr. Bush told a group of Asian reporters this week.

In a move designed to quash speculation that China will continue to revalue its currency, Chinese financial regulators have enacted new rules to limit indirect hedging of the Yuan. Apparently, many businesses with operations in China had been delaying payments to their American suppliers, with the expectation that another revaluation of the Yuan would indirectly lower their payment obligations. As a result of the new rules, these accounts payable will now be treated as foreign exchange accounts and will be subject to certain rules and fees. The Wall Street Journal reports:

Friday’s move also suggests Beijing sees signs that companies continue to position themselves for a further movement beyond July’s 2.1% revaluation of the Yuan, as the US and other governments pressure Chinese authorities to do more.

Last week, the Group of 20 industrialized and developing nations met in Beijing to discuss pertinent economic issues. As you can probably guess, the Yuan revaluation was at the forefront of the agenda. When criticized over the nominal 2% revaluation that China effected in July, the chairman of China’s Central Bank offered a Chinese proverb: “crossing the river by touching the stones,” meaning China would prefer to take small steps towards revaluation rather than one or two giant leaps. China also insists it must improve its banking system and financial institutions before it will consider floating the Yuan. While the testimony was predictable, analysts nonetheless reacted with dismay. Dow Jones News reports:

“The long term position is for the Chinese market to liberalize, to become more liquid and to be accessible to international investors…but I would be at the long end of 3-5 year period at least.”

While nearly 3 months have passed since China famously revalued its currency, the subject remains a hot political issue in America. Several politicians, led by Charles Schumer, are again fighting to pass a bill that would levy a 27% tariff on all Chinese imports, if China fails to fully revalue within one year of the bill’s passage. This bill is supported broadly by small businesses and middle market American companies that feel they are being squeezed by low-cost Chinese labor. On the other end of this debate stand multinational companies, many of whom have opened production facilities in China to take advantage of this low-cost labor. These multinationals, which are understandably against Yuan revaluation, have much more political clout, which may explain why President Bush has stubbornly refused to take action against China.

In the latest chapter of the revaluation saga, China will allow the Yuan to fluctuate more against most major currencies, excluding the USD. While this move has already ignited speculation among currency traders that another revaluation is imminent, closer analysis reveals this latest decision was motivated chiefly by practical considerations. For all intents and purposes, the Yuan remains pegged to the USD but can freely fluctuate against other currencies.

When China revalued the Yuan in July, it announced that the Yuan would not be permitted to fluctuate by more than 1.5% against non-USD currencies. In a recent trading session, however, the Euro appreciated almost 1.5% against the USD. If the Euro had appreciated further, it would have created a triangular arbitrage scenario whereby the Yuan-USD and Euro-USD exchange rates were not consistent with the Euro-Yuan rate. In order to prevent such a situation from occurring, China will now allow the Yuan to fluctuate up to 3% against major currencies.

Today marks the two-month anniversary of China’s landmark decision to revalue the Yuan. American policymakers have since had much time to reflect on the move, and the consensus is predictably, that China still needs to do much more. In theory, because China permits the Yuan to fluctuate .3% daily against a basket of currencies, the Yuan should appreciate by .3% every day. However, China has massive forex reserves and is thus able to maintain the Yuan’s peg fairly easily. In the beginning of November, the US Treasury is scheduled to release a report on currencies, in which it may officially label China a ‘currency manipulator.’ Irrespective of this report, several prominent politicians have threatened to reintroduce legislation that will slap a 27.5% tariff on all Chinese goods. The Washington Post reports:

“We’re still in the very early stages of what is, for them, a new regime,” said Timothy D. Adams, undersecretary of the Treasury for international affairs. “And thus far, I think we — the United States, the G-7 and other institutions — have been both supportive and patient. But we have expectations that greater flexibility will occur over time.”

Two prominent economists recently conducted a thorough analysis of Asia’s increasing foreign exchange reserves, the majority of which are held in US Treasury Securities, which are of course denominated min USD. The economists argue that the while the collective forex reserves of Asian nations have indeed skyrocketed in recent years, this does not necessarily signify that outright currency manipulation is taking place. Rather, they believe that these nations use their reserves as tools of monetary policy. For example, Japan may have grown its reserves to try to mitigate the possibility of deflation. Other nations view their reserves as a sort of contingency, to be used if the 1997 Southeast Asian economic crisis (which caused regional currency depreciation) repeats itself. China’s increasing reserves, argue the study’s authors, are largely a product of ‘hot money’ inflows, rather than a proactive attempt by China to hold down its currency. The Economist reports:

It is hard to accuse China of running a cheap-currency policy, since it passed up an opportunity to devalue the yuan at the time of the Asian crisis.